The distinct possibility of a crash

Technical trading is a game of probabilities involving indicators, patterns and history. There are times, like near the peak last month, when the odds of a certain outcome are very high, since you have so many indicators in positions that have been followed by the same outcome. There are other times, like right now, when you don’t have strong odds of any particular outcome, but you do have a higher than usual chance of a rare outcome: in this case, a violent resumption of the deflation trade from relatively oversold conditions. A hard decline from oversold conditions can lead to panic, since it feels like the market “just isn’t going to stop falling.”

I still very much like the summer 2007 analogue, since this winter, as then, the market fell hard off of a very long and calm stretch of gains on low volatility and extreme complacency (the “Goldilocks era”). What I see now is a market that, with yesterday’s rally to 1080 and this week’s little ramp in DSI bullishness, has corrected its oversold condition just enough to resume the decline. Stock bullishness now has 20% or so of downside to go before reaching the level seen at the bottom of declines of this nature (hard first plunges from long periods of complacency: May-June 2006, Feb-March 2007, July-August 2007, Oct-Nov 2007).

The VIX has the room to spare, as does the put:call ratio. I see in early trading this morning that several markets are showing weakness as they approach support. It is still possible that they bounce and we charge ahead towards 1100 and beyond, but I would not count on it. Like I said a few days ago, and Daneric actually mentioned last night, perhaps this decline resembles the start of wave 3 of primary 1 (May-July 2008), a stair-step process of small rallies just big enough to keep people guessing, followed by new lows.

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I’ll be away from the markets for the next few hours, unfortunately, but I have sell-limit orders in place for the above possibility. This of course would negate the Euro rally I’ve been considering.

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