Finally, a reality check. During the past six weeks stocks staged their strongest short-term rally in more than 70 years. At the vanguard of this advance were the banks which also lead pack on the way down. Thin threads of hope that the nation’s largest banks are turning the corner (thanks to ample use of questionable accounting), encouraged investors in bid up the financial sector an astounding 78 percent at their recent peak.

 

As you know, no market moves in a straight line. Although a case can be made that stocks are still oversold on a long-term basis even after their recent run, they have become very overbought on a short-term basis. Our short-term market timing indicators are sounding the alarm as they have become more and more bearish with each tick higher in the major averages.

 

From a sentiment point of view a correction unfolding isn’t the least bit surprising either. Each week the Chicago Board Options Exchange publishes data on the amount of outstanding put and call options. From a contrary standpoint a high ratio of puts to calls (a preponderance of bearish bets) is bullish, while a low reading is bearish as it demonstrates high optimism. The put/call ratio has been falling as stocks have advanced and last week we had a pretty clear indication that we were at an extreme as the ratio fell to its lowest level since the market top in October, 2007.

 

Yesterday’s decline was broad based, with no sector spared in the selling. The financials were the hardest hit, declining more than 8 percent as group. The average stock on the New York Stock Exchange, meanwhile, gave up more than 5 percent. One indication that more selling lies ahead can be gleamed from the relatively light volume that accompanied yesterday’s decline. In addition, with only seven decliners for every advancing issue, the action suggests more of a retrenchment is in the offing.

 

We’re confident stocks are headed lower from here. The next important support area is down around 820 or so on the S&P 500. A break below that area will presage further selling, with a retest of the lows a distinct possibility. We look to profit from that decline with the put options we’re holding. But we won’t be happy if our forecast comes to pass as a correction will also mean lower share prices for stocks we’re holding for the long haul. A big decline will also likely postpone the economy’s recovery.

 

An important lesson we’ve learned over the years is that you should never trade just for the sake of trading. We’ve been reluctant to take on new positions in recent weeks because while our indicators were becoming increasingly bearish, it’s extremely risky to fight the tape, which was being painted green day after day.