Get Ready for the Next Leg Down
By Jeff Clark
August 9, 2007

"This is the worst credit market in 22 years."

That quote from the chairman of Bear Stearns sent the market into a tailspin last Friday and erased the 250-point gain the Dow enjoyed on Wednesday and Thursday. It also sent the S&P 500 to another new low for this correction.

So, how do you trade a market that reaches hugely oversold conditions, gaps higher one morning, rallies nearly 200 points in the final half hour of trading one day, falls 280 points in eight minutes the next day, and then runs up over 400 points during the next three trading sessions?

The answer is... you don't.

Trying to trade this market is like trying to predict the flight pattern of a housefly. One minute, it's circling around the kitchen. Then, just as you think you've timed it well enough to reach for the swatter, the little pest bolts toward the living-room window.

You can chase the fly all day long. But it's faster than you, and you're likely to waste a lot of time and energy. In the end, it's best just to let the little bugger tire itself out. Then, as the fly is resting on the windowsill and catching its breath, you can grab the swatter and deal with it appropriately.

Last week, the stock market was circling around my kitchen. The oversold conditions on Monday and Tuesday led to a predictable bounce on Wednesday and Thursday. I thought that was the start of the "B" wave bounce that I wrote about last week. But, just as I geared up to make my move, the market bolted toward my living-room window on Friday.

As you can see from the following chart of the S&P 500, that bounce actually started on Monday...

Remember, though, that a "B" wave bounce is just a bounce. Ultimately, we should see a "C" wave decline that takes out the "A" wave low and creates the real bottom from which another rally can begin...

This whole process may take a couple of months to get through.

It still looks like the upside on the S&P 500 could be as high as about 1,510–1,520 or so. And we got within spitting distance of that level at one point on Wednesday.

The market is now just about as overbought today as it was oversold last week. If you got caught a little too aggressively long when this correction started two weeks ago, then now looks like as good a time as any to lighten up on those positions.

And, if you’re inclined to bet on the short side, well, it looks like we have a much better opportunity today than we did last week.

Best regards and good trading,

Jeff Clark