Stocks Under Pressure as Fear Rises

It was another nasty day for the market, with the major averages slammed into the closing bell to finish on the lows as the correction entered the third day.

Small caps are leading the way down, with the Russell 2000 down 7.5% from its July highs and down 3% for the year-to-date. The Russell 2000 also recently suffered the indignity of a “death cross” — when its 50-day moving average dropped below its 200-day average for the first time since 2011. While not a great market timing signal, it’s indicative of just how serious the selling pressure has become.

That’s news to most investors, given that the percentage of bearish respondents to sentiment surveys had recently dropped to levels not seen since 1987 as the Dow Jones Industrial Average and the S&P 500 have both been flirting with record highs. But the appearance of back-to-back Hindenburg Omens late last week, as well as evidence of growing fear in the options market and signs of significant technical weakness, suggest the selling is going to continue.

News flow was relatively light, with a couple of Federal Reserve officials on the tape. The notable one was moderate St. Louis Fed President James Bullard. He said it would be natural to drop the all-important “considerable time” phrase next month, which refers to how long the Fed will wait to hike short-term interest rates after the QE3 bond buying program ends in October. He added that he still saw the timing of the first rate hike around March.

That’s at least three months sooner than Wall Street has penciled in as the markets continue to lag behind the Fed’s own projections of the path and timing of its rate tightening cycle.

Also weighing on the tape was the start of U.S. airstrikes against Isis targets in Syria as well as weakness in IPO sweetheart Alibaba (BABA). Weak economic data out of Europe was also a problem, pushing iShares Europe ETF (IEV) down and out of its month-long consolidation range. And emerging market stocks are an ongoing drag with the iShares MSCI Emerging Markets ETF (EEM) down another 0.6% to bring its total decline from its highs earlier this month to 7.2%.

Fear is on the rise, as represented by the CBOE Volatility Index, which pushed toward the 15 level for the first time since early August options traders bid up put option protection against further market weakness. Another measure of options market sentiment, the SKEW Index, has jumped to tie the highest level since 1989 as traders bet on the risk of a “Black Swan” type market disruption.

Technically, a big warning sign is being flashed by breadth measures that indicate how many stocks are moving to the upside. Currently, despite the fact the S&P 500 is just incrementally off of its record high, less than 71% of the constituent stocks in the index are in uptrends. That nearly matches the low set in early August after a 4.3% drop and is well off of the high of 85% set back in July.

S&P 500
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Translation: The market is weaker than it looks.

For now, I’m recommending investors maintain a defensive, cautious stance by raising cash. For the more aggressive, consider short plays or put options against pockets of weakness. The Oct $17 Ford (F) puts I recommended to Edge Pro subscribers earlier this month are up more than 73%. New recommendations include positions against Intel (INTC) and American Airlines (AAL).

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.

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