The Bearish Case For Equities

From this perch, the bearish case for equities is really one of sentiment. The "smart money" is bearish and the "dumb money" never really got too bearish after the mid - January correction. As discussed in "Why I Think We Need To Go Lower Before Going Higher" this is a market "call" where context matters. The best dips to buy are those where the "dumb money" turns bearish and the "smart money" turns bullish. Neither of these happened after the mid - January correction. It would be my expectation that a modest sell off will lead to a modest bounce. Therefore, I would be a seller as prices approach the January, 2010 highs.

From a technical perspective this is also the correct play. Why? Let's take a look at figure 1, a weekly chart of the Ultra Short S&P500 ProShares (symbol: SDS). Remember, this is a 2x leveraged product that goes inverse to the general market. The pivot points inside the gray ovals are key pivot points. They are "key" because they occur at a time when investor sentiment is overly bullish towards the equity markets. Key pivot points act as support and resistance, and it is around these areas that markets tend to change.

Figure 1. SDS/ weekly

As an example, take a look at the 2 key pivot points at the left hand side of the chart. Point #1 was from July, 2007 and point #2 was from October, 2007. Market participants were overly bullish at both points and we can see that in July, 2007 SDS pivoted and went higher - i.e., market participants were wrong in their outlook and the bears won this time. This formed key pivot point #1.

The story doesn't stop there as we fast forward to October, 2007 when the key pivot point #1 was actually retested. In fact, the SDS closed below key pivot point #1 suggesting that "this time was different" and the trend was going to continue higher for equities and lower for the SDS. But prices quickly reversed and the market top was put in trapping a lot of bulls.

So let me recap. Back in 2007, we were in a confirmed downtrend for SDS. Because of this, the first key pivot should not be bought but a retest of the key pivot point should be. If prices close below the first key pivot point, then there is reason to believe that the down trend will continue. But reversals are common - that is why they call it the "dumb money" and "smart money". A reversal back above key pivot point #1 suggests that the down trend for SDS had ended.

Now let's move to 2010. Referring back to figure 1, we have our most recent key pivot point (labeled #3) at 33.57. Because it is a down trend, we don't buy the first pivot point, but we wait for prices to either retest that area or close below the pivot point and trade back above.

So let me recap the bearish case for equities: 1) it is a matter of context; without money on the sidelines -i.e, the "dumb money" is all in, the market will not move higher; 2) technically the market is setting up for a breakout or a reversal.

I have utilized the SDS as an example to give you an idea of how to understand the price dynamics. A weekly close below the 33.57 key pivot suggests continuation of the trend. A close below the 33.57 key pivot and close back above this pivot suggests a reversal and likely market top. You can bet wrong, but don't be wrong for long as you know the key price levels to watch for.

Lastly, I don't see this market top as being a cyclical bull market top. But is should be a top that leads to a better buying opportunity.