It’s said that selling ice to an Eskimo is no easy task. It’s also said that if things look too good to be true, … they probably are too good to be true. For stocks, this was the case just four short weeks ago. Up until the April 26 top, the Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) had rallied some 75%. During much of the last leg up, none of the indexes declined more than 1%. Wall Street had forgotten that the stock market can move in two directions.
Don’t worry, be happy Investors’ interest for downside protection was as fridged as an Eskimo’s desire to buy ice. Savvy investors looked at the CBOE Equity Put/Call Ratio and scratched their head. Why? Because the interest in protective put buying had dropped to levels not seen in nearly a decade. On April 16, the ETF Profit Strategy Newsletter explained why this is a big fat red flag: “The put/call ratio in particular can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses occurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels, however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell; selling results in more selling. This negative feedback loop usually results in rapidly falling prices.” Only six trading days later, the big fat red flag became a reality. 15 of the next 21 trading days were down days. One of them, Thursday May 6, saw the Dow Jones (NYSEArca: DIA) tumble nearly 1,000 points in a matter of hours, the S&P (NYSEArca: SPY) dropped more than 100 points and the Nasdaq (Nasdaq: QQQQ) dropped more than 200 points. Where is fat-fingered Freddy? Still in denial, Wall Street was looking for scapegoats. Greece’s debt problems were the obvious cause, even though we’ve known about them since the beginning of the year. Up until April, stocks were actually rallying every time a new bailout package was allegedly approved. There were also rumors about a clumsy, fat-fingered trader who accidentally sold a billion instead of a million shares. Yesterday, Reuters reported that U.S. regulators may never know what caused Thursday’s market free fall. That’s probably because reality simply caught up with the market. That happens, usually when least expected. Huge one-day gains are bearish But the reason for the decline seemed to be a moot point. That same day, stocks roared back and two days later (Monday, May 10) the Dow soared 405 points after its third largest gap up opening ever. Investors thought they were safe after Thursday’s “glitch” and Monday’s rally. At first glance Monday’s bounce seemed bullish. Here’s what the ETF Profit Strategy Newsletter observed: “History tells us this is not bullish. We’ve found 16 instanced where the DJIA rallied 400 points or more, 12 of them hit during the post-2007 decline, most of them in September/October 2008.” The chart below was published in the newsletter on May 14 and shows that big bounces tend to happen during the largest declines. The newsletter concluded that “the next leg of the decline should reduce the indexes to levels lower than seen on that Thursday (S&P 1,066) and significantly below the lower acceleration band at S&P 1,042. 
The question is, what constitutes “significantly below” and what comes after “the next leg?” Based on acceleration bands, moving averages, candle formations and pivot points, it is possible to identify a number of support and resistance points (more about that later), however as the chart above shows, if we have entered territory similar to the September/October 2008 decline, the direction for prices will be down for the next days, perhaps weeks. How low can stocks go? A fair share of investors have missed out on much of the rally from the March 2009 lows and are waiting for an opportunity to “buy on the cheap.” As long as this attitude persists (and we see from the comments on ETFguide.com it still does), there is 1) significantly more downside risk and 2) it explains the big one-day bounces amidst a vicious decline. Why more investors were thrilled to buy stocks at Dow 11,000 than at Dow 7,000 is one of those wonderful stock market anecdotes that will remain a mystery to many and thus preserve certain market patterns. What isn’t a mystery is that valuations and perception drive prices. As long as stocks (NYSEArca: TMW) are perceived to be cheap, or at least not expensive, investors will buy them. The following Bloomberg headline from April 26 (the day stocks peaked) shows how easy it is to marry valuations with perception: “U.S. stocks cheapest since 1990 on analyst estimates.” In other words, based on projected earnings, stocks are the cheapest since 1990. Over the past decade, we have seen three bubbles burst – the tech (NYSEArca: XLK) bubble, the real estate (NYSEArca: IYR) bubble and the financial (NYSEArca: XLF) bubble – yet we still seem to confuse projections with reality. The highly inflated earnings analyst project may never come true – they sure didn’t in 2000 and 2007 – and thus, with rising P/E ratios, stocks all of a sudden become expensive. As profits fall, P/E ratios rise.  Perceived valuation
At one point in late 2009, P/E ratios based on actual earnings, published by Standard and Poor’s pierced above 140. The historic average is about 15 – 20. P/E ratios are wonderfully simple. Perhaps that’s why many Ivy-League Wall Street gurus don’t pay enough attention to them. If you plot historic stock prices against historic P/E ratios, it becomes very clear that there is a predefined correlation between the two. Stocks tend to top when P/E ratios peak and bottom when P/E ratios fall to lows. According to Professor Shiller, the stock market is about 30% above its historic mean. In other words, stocks are overvalued by 30%. But (and that’s a big but), stocks don’t bottom at their mean; they fall significantly below their average. Just as perception can keep stocks in overvalued territory, perception can push stocks into grossly undervalued territory. In plain English, the downside risk is huge. http://www.etfguide.com/ | 
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