Securities Research Services

Monday, July 07, 2008

Two Possible Ways Stocks Can Fool The Crowd

There is a wide consensus that stocks are oversold and chatter is getting loud in expectation of an oversold rally to form from current areas. If you read our last report you will note that we were also expecting this.

There are reasons developing that are developing to be dubious about this proposition. It's good to be highly suspicious when the majority of commentators are all looking for the same scenario to unravel. Aside from this, there are some compelling reasons to consider that stocks might just not be a good buy at current levels.

Fear levels have remained at a constant neutral position even as prices for the SPY have been retesting that all important $125 level we have been discussing in recent reports. A good way to quantify this is to check out the strong divergence between the VIX (fear index) and the price of the SPY.

A quick scan of the VIX reveals that in January and again in March, when the SPY tested $125, the VIX spiked up past $35. This means that during those two tests fear levels revealed a crowd that was in panic mode offering buyers a great contrarian reason to buy aggressively.

But now we see SPY back at $125/$126 and the VIX is only trading at $25, a very strong negative divergence. Moreover, volume levels hardly show that contrarians are buying at current levels. Without volume and without fear it is hard to imagine that stocks can put together a sustainable rally from current levels. Moreover, oil is a whopping 35% higher now than it was back in March, which makes it all the more likely that SPY $125 is destined to move from its position of support to a position of resistance.

So, since the crowd is looking for a bounce here, let's consider two other possibilities that just might unfold next.

Possibility #1

The first possibility is that buyers at $125 will get quickly burned as prices fail to bounce at all. Those recent buyers should be considered weak handed players and when their stops are hit a waterfall-type decline could potentially ensue; or something like a mini crash.

Possibility #2

Prices bounce weakly but quickly fail at the falling 20-day average leading to an eventual break of $125.

Either way, the market should be looked at with a high degree of skepticism at this point. Even metals and energy are getting crushed here leaving no safe harbors on the long side of the tape.

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