The 911 debacle was very similar to the debacle we saw last fall in the sense that it was a black swan event....i.e. extremely improbable. In both periods the economy was already weak but the black swan events accelerated the downturn causing the economy to grind to a halt... literally. But an economic recovery and big stock market rally ensued. In fact, the recession was actually over in 2001....but that didn't prevent the last and most brutal down leg of the bear market to occur in the months ahead of 2002.
Right now we are seeing the economy bounce from a very depressed state late last year just like after 911. We've had a big 3 month rally just like after 911 and now we've been going sideways for a couple of months. Before the market rolled over in 2002 there was a massive head fake that occurred in February 2002. Traders went for the kill and aggressively shorted the market in February when it appeared like it was rolling over. How do I know traders were aggressively shorting? Take a look at how the Rydex ratio (adjusted for cash flows) below was behaving along with how the market was behaving. Without going into painful details, basically, the rydex ratio is a measure of trader sentiment. The higher it is the more traders are betting against the market than for it. It is useful as a contrary indicator.
Notice how the Rydex ratio exploded upwards in February 2002 to levels that exceed bearishness seen at the 911 lows. This was unjustified bearish sentiment given that the market had only pulled back moderately. The surge in bearishness created the fuel for a sharp rally back to the highs by early March 2002. That rally really sent the bears packing as sentiment completed reversed. Think about what they just went though...they basically shorted the entire post 911 rally with nothing to show for but losses and then, just like when it seemed like the market was rolling over for good, traders aggresiviely shorted thinking that finally they would be vindicated. But when they go burned again, that was the last straw. They gave up for good this time or if they did decide to go short again, they vowed not to get greedy and take profits quickly. This of course set the stage for the final bear market down leg.
You see, in order for a bear market down leg to occur, markets have to get to the point whereby investors drop their guard thinking that the coast is clear and the bearishly inclined folks have to be humbled to the point where they are too afraid to short or if they did, went small and took profits quickly fearing another upside spike could bushwhack them again at anytime. Regardless of the fundamentals, when the shorts get bold the market spanks them good just like last week.
Now take a look below at the rydex ratio over the past few months. Notice, how just like in February 2002, traders aggressively piled into the short side as the market appeared to have rolled over from a high, in this case the June 2009 high. Now you can see how the rydex ratio is quickly becoming unwound after the big rally we've had. It’s not at the opposite extreme yet, but if we continue to see the rydex ratio collapse from here with the market only making marginal gains then I believe we may have a situation similar to March 2002 which was a major top leading to serious downside.
I'll be keeping a close eye on the rydex ratio and the VIX in the coming days. Next week will probably be choppy. With the NASDAQ up 8 days in a row, it's likely a bit of colling off at the very least is in order.
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