Tuesday, 15 March 2011


Japan's Nikkei 225 March 15th 2011:
a two day drop of almost 20%, the biggest since the crash of 1987

On a day when Japan's technicians are risking their lives fighting to prevent a Chernobyl-style nuclear meltdown and the country continues to count its dead, discussions about the stock market fallout inevitably sound misplaced.  

Unfortunately, the world turns regardless; major swings in world markets and our financial fortunes are happening whether we feel it's right to talk about them or not - and my job here is to try and make some kind of sense of it all, gentle reader, for us both.  So let's take a cool look.

FTSE 100 index, 1pm March 15th 2011.
The red circle is the date I posted my correction warning.
The blue circle bottom right is the RSI, a momentum indicator which suggests we are much closer to the end of it than the beginning.

It may have taken a revolution, an earthquake, a tsunami and nuclear meltdown to do it - which says more about the power of the Federal Reserve and QE2 than Ben Bernanke ever could - but the correction I've long anticipated in these columns has finally woken investors from their slumber.  Those who are thinking of taking evasive action now, however, are probably too late. 

Throughout market history these 'unforseeable' natural and man-made disasters have struck with predictable regularity, yet the market's survived them all.  This time will surely be no different.  Given my long-term bearishness, you might expect me to be screaming sell, sell, sell.  Whoa there, horsey.  

Chernobyl nuclear disaster 1986 as reflected in the Dow - an echo may be being sounded today, see below.

Recently I've been agnostic on whether the peak I was calling for would mark a major top, or merely a final staging post on the journey.  On a technical basis I still can't rule out the former but historical precedents, residual market momentum in the US and incessant Fed-inspired buying pressure set to last into June makes me more inclined to think it's the latter.  So should we buy here?


Usually, the moment of maximum uncertainty - which closely follows the moment of maximum panic - is the time to buy.  As soon as the situation stops getting worse (or gets worse but at a slowing pace - neither of which are the same as getting better) the anticipatory reactions of traders kick in and catastrophe starts to look a lot like opportunity.  So unless the situation at the Fukushima plant deteriorates rapidly or middle-eastern conflicts escalate we seem, on a near-term outlook, very close to that point.

But there is a sucker punch the markets can often throw which is worth keeping clearly in mind.  A sudden hit such as we've taken tends to bring its own aftershocks, as nervous traders push the ejector button at the first subsequent sign of trouble and institutions suddenly need access to cash.  

Traders receiving margin calls, insurance companies needing cash to pay claims (in this case of course, in Japan), hedge funds and mutual funds needing cash to satisfy clients who want to bail... this often creates additional selling pressure down the line, especially once markets have enjoyed an initial rebound.  In this situation, there is no safe haven.  Gold, oil, bonds, currencies: anything not nailed down is sold.


The reaction to the Chernobyl disaster back in '86 provides one example (more on that in a moment) but here's another from February 2007, which occured after a similarly long, deceptively smooth run up in prices.  

An unexpected economic diktat one Sunday by China's men in grey chopped the Shanghai market off at the knees, provoking a 5% plunge in world markets on Monday morning.  After a day or two to gather their thoughts, investors decided the situation wasn't so bad after all and treated it as a buying opportunity.  They weren't wrong - just early.  

Markets rebounded a little into March before hitting an overhead cloud of sellers.  At that point anyone who was unsure decided to eject and we saw two days of fierce selling leading to a new low.  The correction was over.


Take another look at the stock market reaction to Chernobyl, above, then check this schematic of S&P500 prices directly following the disaster, courtesy of Brad Sullivan at Hamzei Analytics.  Day 1 on the chart would be the 1986 equivalent of our market on Monday 14th March; as I write, we've just endured day 2.    

As you see, the same essential pattern plays out:  

  • Initial shock and panic leading to a temporary low  
  • A brief period of stabilization and a gentle rise  
  • When the market hits overhead selling pressure, traders lose their nerve and a dash for cash begins, leading to a new low
  • Major buyers step in and the correction is over

In fact this classic investor behaviour has manifested twice before in the past year, once in a huge correction and once in a tiddler.

Trying to figure out whether and when we might hit a new high when there are so many potential booby traps strewn before us - a middle-east revolution and oil price hikes being only the most obvious two - is a mug's game. Indeed this environment may end up being most profitable for shorter term traders, for whom this is a heaven-sent opportunity to 'buy the dips and sell the rips'.

And while the final two-thirds of the year might prove frustrating if you're a long term investor, you can still be confident of winning through a combined strategy of diversification and timing, as I recently set out in my three-part series, The Compleat Investor