Down 10% in 10 Days – How Much Worse Can it Get?

It was in the 1960s when Liza Minnelli and Joel Gray sang Money makes the world
go around, and it was as true back then as it is today. The more money, the
faster the financial world spins and vice versa. Money/liquidity is as important
for the stock market as gasoline is for a car. Since the Feds QE2 inflated a
liquidity-based bubble, the key question was where the money will come from once
QE2 ends. As long as there is no QE3, the issue of money flow is one of the keys
to deciphering the future for stocks (NYSEArca: VTI). Published below is a
revealing piece of cash flow analysis featured in the June 2011 issue of the ETF
Profit Strategy Newsletter (released on May 20): Dont Fight the Money Trail QE2
one of the sources that has been copiously showering Wall Street is about to
come to an end. Will there be enough new cash on the sidelines to continue
driving up stock prices? The chart below says a thing or two about investable
cash and how much is left. At the top we see the S&P and the giant M-pattern
discussed previously. Illustrated below is a measure of investable cash. Using
NYSE figures (latest available as of March), Ive deducted free credits
(available cash) from debit balances (margin debt) to come up with investable
cash. Shown at the bottom of the chart are mutual fund cash levels. Investable
cash in March was almost as low as in June 2007. There are two variables that
might be affecting investable cash: 1) Interest rates are lower today than at
the previous investable cash lows in 2007 and 2000. This means margin accounts
could expand further. 2) The number of creditworthy borrowers and lending
activity has gone down, which may keep a lid on investable cash expansion.
Mutual fund cash levels are easier to interpret. They are at 3.4%, an all-time
low. The numbers allow for only one logical conclusion. Without the generous
monetary policy (QE2 is slated to end June 30) there is very little new cash
left to drive stock prices higher. Without that cash fix the market will crash
like an addict forced to go cold turkey. Bad Timing The Feds withdrawal from the
stock market came at the worst of times because: 1) The S&P was forming the
giant bearish M-pattern shown above 2) Seasonality turns bearish from June
October 3) Europe had been playing Whac-A-Mole with its debt problems 4) The
Feds QE2 failed to lift the economy and investors became suspicious 5) The
financial (NYSEArca: XLF) and banking sector (NYSEArca: KBE) was weak The
bearish M-pattern wasnt on anyones radar, thats what makes it so powerful. As
per the ETF Profit Strategy Newsletters interpretation, a move above 1,369 would
render the pattern complete. The April 3 ETF Profit Strategy update stated:
There is strong Fibonacci projection resistance at 1,369. In terms of resistance
levels, the 1,369 1,382 range is a strong candidate for a reversal of
potentially historic proportions. How Much Worse Can it Get? The S&P (SNP:
^GSPC) has lost over 10% in 10 days. The Russell 2000 (Chicago Options: ^RUT)
lost 15% in 10 days, the Dow Jones (DJI: ^DJI) 10% and the Nasdaq (Nasdaq:
^IXIC) 9%. The VIX (Chicago Options: ^VIX) recorded its biggest gain since last
years Flash Crash. How much worse can it get? The answer is probably two-fold:
1) Stocks will only fall so long before they bounce. After such a sizeable drop
there will be some kind of a bounce, probably even a powerful relief rally. 2)
Stocks dropped below two multi-year trend lines. Technical analysis 101 suggests
a change of trend from up to down has occurred. From a trading point of view the
current constellation is tricky. The market is oversold, but some of the biggest
declines occur in an oversold condition (this is the reverse scenario of the
late 2010/early 2010 bull run). Thanks to a contribution by an astute
subscriber, the August 2 ETF Profit Strategy update noted the following about
the VIX: The VIX is currently climbing the upper Bollinger Band.