Liquidity Crisis And Mixed Sentiment = More Ugly

Under normal market conditions we would argue that the market is very oversold, and with sentiment levels turning extremely bearish according to SentimentTrader, that the market is due for a minor relief rally or at a minimum a period of sideways consolidation.

We tend to think that this is just the case.

However, the fly in the ointment may in fact be that this time things are different. Banks are reeling in liquidity by refusing to give out loans and calling in margins. This is forcing the big players, such as The Carlyle Group, to liquidate their positions. This may mean that the goal posts are being moved back and that prices may need to overshoot to the downside rather than regress to the mean, which would be a reasonable expectation under normal conditions.

The bottom line, it looks like the short side still has room to move. At the same time, be careful and keep your stops tight so as to lock in profits should prices decide to regress to the mean as they are apt to do.

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Outlook:

Oversold may beget more oversold unless the market starts to see more liquidity due to a government bail out or Fed action. Meanwhile, watch for a capitulation spike down to occur sometime over the next week or so. A high volume spike to the downside, should it indeed arrive, would be an excellent opportunity to cover your short positions into strength at a handsome profit.

Sentiment:

A word on sentiment here: As noted above, the website SentimentTrader has near term sentiment spiking to the extreme bearish side today. This is a contrarian signal to be careful with short positions. Meanwhile, the VIX still has plenty of room to move before it reaches overly fearful territory indicating that we may be headed for a larger spike to the downside that would give us a capitulation low.

What is most striking to us is more anecdotal. Browsing the Yahoo! Finance Message boards we find that a majority of the writers remain hopefully bullish. In general sentiment readings from the message boards can be categorized as follows: the economy is not going into a recession and the selling is overdone; fear levels are too high so I'm buying the low here looking for a countertrend bounce, and with PE ratios this low stocks are a bargain.

This type of sentiment finding tells us that a lot of traders are holding and hoping. Hold and hope is what happens when the market is in a retreat and the results can be very painful for those traders who are in denial about their losses. Denial tends to lead to acceptance and in the market, acceptance tends to arrive at capitulation, the point where the pain becomes so great that they let go right before the market reverses.

The bottom line here is that as long as the majority is in that hold and hope stage the market has room to move to the downside; perhaps much room.