Trouble and strife. Catch a falling knife? Not on your life.

Posted on Oct 08, 2008 by in Free Letters

Hundreds, if not thousands –perhaps even millions– of traders, investors and technicians are waiting eagerly on the sidelines like the boomer sooners of the Oklahoma land rush hoping to catch the bottom of the panic. This is known in the trade as catching the falling knife. It is not a recommended strategy (what is the difference between a tactic and a strategy? as John McCain would say).

Well, it’s not a good tactic and it’s not a good strategy, so that ought to cover all the possibilities. Just ask the University of Miami portfolio manager who tried to time the bottom in Enron. Got his hands pretty well cut up. Readers of Technical Analysis of STock Trends know that there are all kinds of bottom formations and that V bottoms are not the most common. And they are the most treacherous (see falling knife).

Falling knife market. Put out hand at own risk.

Here a little basic fundamental economic analysis is in order. Raise your hand if you think government measures enacted so far will resolve the fundamental problems with the US economy. Just as we suspected. No hands. (Not even with bloody fingers.) Why is that Professor Bassetti-Keynes? Because there is a destructive down spiral in employment. And, children, unemployed people have difficulties paying their mortgages (not to mention eating). That’s ok — we’ll make the mortgages cheaper. Zero income means that no matter how cheap the mortgage is it can’t be paid. So there are three kinds of mortgages: hopeless and will never be paid, on the brink (hanging on but one paycheck from hopeless) and the John McCain mortgage, or no problemo because Cindy owns the only thing holding the country together at this point — beer. No economic analysis whatever is necessary to estimate how many mortgages of each type are in play at this point.  The most uninformed layman can imagine.

And unemployment? A mere bagatelle compared to the 24-25% of the Great Depression. 7%? I.F. Stone famously said, “The government lies. All governments lie.” How much are they lying about unemployment? What percentage unemployment represents the tipping point?

And, if the downward spiral in employment were not bad enough the vicious cycle of real estate foreclosures and failures is as bad, if not worse. Every new foreclosure adds fuel to the fire.

Here is a long term picture of the market:

Is this present collapsing market a surprise?  Not really. Our systems took us out of the market and went short in January.  It is always instructive to look back and see what the picture looked like at the time the decision was made.  Hindsight is always better that foresight but seeing the picture at the time the decsion was made illustrates the central tenet of technical analysis — that we may not be able to foretell the future, but we can know what to do in the moment.

The contrast to the present is literally breathtaking.  You could do the same thing with an Enron chart.  There is nothing magical about what happened here.  It is simply the exercise of the principle that when the trend changes you liquidate your position.  In the case of the Dow our studies have demonstrated that reversing from long to short is a profitable strategy.  A further technical study followed this analysis attempting to determine the possible  extent of a downtrend.

On March 28 2008 we looked at the formation and said:

March 28 2008 Dow 16000? Flying-Vampire Pigs, Levitating pundits…. Random egg attacks.

Note “A low” and “B low”. If this yearlong formation is a massive top (perhaps a double headed head and shoulders) and A low is its lower boundary then a low of 9680 is predicted. If B low is the defining point the predicted low is 10836. Remember Nils Bohr and the difficulty of forecasting. Again, it is not necessary to believe this scenario to know how to bet. The Dow is in a six month downtrend, the last 2 1/2 months of which are sideways, with lower highs in the sidetrend. The low of 9680 is a probable minimum.

At this moment October 8, 2008 we don’t know what will happen in the market. But it is clear that it is unwise to be long, and being short is very profitable.  Is this the bottom?  No one knows, and you could get cut up fingers trying to catch the bottom.

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