Will the Market Selloff Continue?

by Anthony Mirhaydari | February 24, 2011 5:00 am

Investors were rudely reminded on Tuesday that stocks don’t just go up; they can do down too. And when they do, selloffs tend to be hard and fast. In a matter of days, market corrections wipe out weeks of upward progress.

That’s exactly what’s happening now concerns over bubbling inflationary pressures, the end of policy stimulus and the Fed’s $600 billion”QE2″ money printing operation, and political turmoil in Libya and elsewhere finally broke the back of the post-September uptrend resulting in the worst one-day losses since last August. The weakness continues in Wednesday’s trade.

Everywhere you look, critical support was lost, trend lines were broken, and recent patterns reversed. So, what’s next?

One thing is clear: Tuesday’s drop was powerful. Breadth was extremely negative on Tuesday. There were 2,360 net declining issues on the NYSE, the worst result since last June. And down volume accounted for 91% of total volume, the third 90%+ downside day of the year. There hasn’t been a 90%+ upside day since December 1. All of this suggests that the distribution that has been underway over the last few months is accelerating in a big way.

Also, CBOE Volatility Index (VIX[1]) jumped not only over its 50-day moving average (a line of demarcation between stock market uptrends and downtrends) but it blasted through its upper Bollinger Band as well. A move of that strength hasn’t been seen since last April ahead of a multi-month correction. Given that the VIX, known as Wall Street’s fear gauge, is based on S&P 500 options trading this is a sign that professional investors are frantically moving into put option protection against an protracted selloff.

Many retail investors were caught unaware of this looming change in tone. Small option traders recently ramped up their call option buying to levels not seen since the final days of the dot-com bubble back in 2000. And over-the-country volume in Nasdaq pink sheet issues — low priced extremely speculative stocks — moved to the highest levels relative to the volume in the larger stocks in the Nasdaq Composite since 2006. Back then, the spike in bullishness was followed by a 10% correction.

I think we could be on the cusp of a drop of similar magnitude now.

So the question is whether the forced of liquidity being supplied by the Fed’s $600 billion “QE2” money printing operation can override geopolitical concerns, rising fuel and food prices, fiscal budget battles, renewed concerns over the health of the eurozone, and a drop in earnings growth.

There is some evidence that the Fed’s policy is increasing being fingered as a culprit in many of the macroeconomic issues we now face, from rising food prices to unwanted currency appreciation in countries like Brazil and unwanted credit growth in countries like China. Moreover, the policy is nearing its planned phase out in June. So not only are investors now pricing in a market environment that will soon be without a constant drip-drip of cheap cash, but they are pricing in an environment where that cheap cash is actually seen as an increasingly negative factor.

One thing is clear: Investors sold stocks more heavily Tuesday than they did during the deep one-day drop on January 28. This is a sign that rather than encouraging new demand, higher prices have made traders more skittish and ready to run for the exits at the first sign of trouble. For example, the S&P 500’s component stocks lost 11.6 new points Tuesday vs. the 9.7 points lost on January 28.

Unless we see a big reversal a la January 28, which I think is highly unlikely given the depth and unpredictability of the negative catalysts the market now faces, I’ve recommended my newsletter subscribers maintain a net short positioning for at least a few weeks. And I recommend the same to you. At the very least, look at culling your weak holdings, reducing exposure to highly sensitive cyclical sectors like materials and technology, and work on reducing your overall long exposure.

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned.

Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to Investorplace readers. The author can be contacted at anthony@edgeletter.com[2]. Feel free to comment below.

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