More Fuel For a Bigger Decline

A French proverb states that a fault denied is committed twice. Denial, as blissful as it is for the time being, does not serve as protection against the inevitable.

A perfect example of denial is the May 6 flash crash. Neither Wall Street, the financial media, nor investors wanted to see the danger of such a meltdown beforehand. After it happened, they were in denial about the cause.

Denial is Bliss

The simple truth is that the market was ripe for a major correction. A few weeks before the flash crash, the ETF Profit Strategy Newsletter noted the extremely low CBEO Equity Put/Call Ratio and warned:

'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.'

As it turns out, there was no clumsy-fingered trader at fault for the decline that reduced the Dow (DJI: ^DJI) by more than 1,000 points in one day. If it had been a simple error, stocks wouldn't have fallen to new lows after the flash crash. If it had been a simple error, the S&P (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) wouldn't still be trading below the flash crash close.

The Reality of Denial

But, that's the power of denial. Since the April 26 highs, the S&P has been moving from lower highs to lower lows. On July 1, the S&P had arrived at 1,011. The ensuing rally lifted the markets by nearly 10%, but failed to push the S&P and Nasdaq above the July 21 highs. The July 21 highs failed to move above the May 12 highs. The May 12 highs were significantly short of the April 26 highs.

Despite the obvious downtrend, investors get as excited about dead end bounces as ever. This is not a bullish omen. In fact, according to the ETF Profit Strategy Newsletter's technical analysis, the steepest leg of the decline is still ahead. Before we look at more technical details, let's browse through some fundamental factors that reflect the current state of denial:

Don't Worry About Bank Failures

111 banks were added to the FDIC's failed bank list thus far in 2010. At the same time last year, only 76 banks had been shut down. According to an FDIC press release, Metro Bank of Dade County had total assets of $442.3 million and total deposits of $391.3 million.

Assets outweigh liabilities by $51 million. That's good, but apparently not accurate. According to the FDIC's press release, closing Metro Bank will cost the FDIC $67.6 million. Why? Because an accounting trick allows banks to artificially inflate their assets.

The accounting trick allowed this small bank to overstate its assets by about 25%. Other banks on the FDIC list overstated their assets by more than 50%. Imagine the size of the problem, considering that the four biggest banks (NYSEArca: KBE - News) of the country have about $7.5 trillion in combined assets. We should also point out that none of those losses technically affect earnings, at least not yet (for a detailed analysis refer to the June issue of the ETF Profit Strategy Newsletter).

Don't Worry About Falling Real Estate

The National Association of Home Builders reported that its monthly reading of builder's sentiment about the housing market sank to 14, the lowest level since March 2009.

Unlike other economic indicators, this index is taken from builders that have their finger on the pulse of Main Street and is forward looking. Despite the rally in equities (NYSEArca: VTI - News) and real estate (NYSEArca: IYR - News), homebuilders (NYSEArca: XHB - News) never really saw light at the end of the tunnel.

Don't Worry About Foreclosures

According to RealtyTrac, more than 1 million American households are likely to lose their homes to foreclosure this year. This is about 10 times as high as during an average year. 25% of the U.S. household sector has a sub-600 FICO score.

Yet, Fannie Mae is offering financing to first-time buyers who only have a $1,000 down-payment. Nearly $150 billion have been spent to keep the doors of Fannie, Freddie and company open. 

Does it make sense to artificially extend the life of a patient destined to die? In the case of Fannie, politicians seem to think that lending more money and ultimately creating more toxic assets will solve the problems. Even a third grader understands the irony of that concept. Denial is alive and well.

Don't Worry About Bankrupt States

States are in trouble. The bigger the state, the bigger the trouble it seems. California has a $1.8 trillion economy. If CA was a country, its economy would be the seventh biggest in the world, bigger than Russia. But, CA has no money.

CNN reports that as many as 200,000 state workers in CA could see their pay scale slashed to minimum wage, if orders from the governor's office are followed. You don't need to be one of the 200,000 to know that is bad. To go from state salary to minimum wage is a huge drop.

Don't Worry About Falling Prices

Look around and you see a general downtrend develop: U.S. stocks (NYSEArca: IWB - News), international stocks (NYSEArca: EFA - News) and emerging market stocks (NYSEArca: EEM - News). The same applies to commodities (NYSEArca: DBC - News), real estate prices (NYSEArca: RWR - News) and consumer goods.

The above-mentioned 'don't worries' all contribute to the deflationary spiral (see image below for a visual). Unemployment remains high because businesses have no pricing power. This leads to lower income, default foreclosures, and ultimately even higher unemployment. Even Bernanke knows, there is no easy fix to a deflationary cycle. Once engrained, it feeds on itself.

 

Don't Worry About Death Crosses

A death cross is one of the most powerful technical indicators. It occurs when the shorter simple moving average (SMA) crosses below the longer SMA. Over the last few weeks we saw literally dozens of such death crosses.

Most notable was the S&P, Dow Jones and Nasdaq experiencing not only a death cross created by the 50 and 200-day SMA, but also courtesy of the 10 and 40-week SMA. Despite the rally from the July lows, the sell signal triggered by the various death crosses remained active. The fact that the Dow Jones was the only major index to rally above the June 21 highs provides an additional bearish non-confirmation.

Over the past ten years, the buy/sell action triggered by the SMA crosses has a success rate of 75% - 100%. Winning trades outperformed losing trades by a ratio of at least 3:1.

In investing, those are not the kind of odds you want to bet against. In other words, it's time to face reality and abandon denial. 

Leading up to the April highs, the ETF Profit Strategy Newsletter noted a pinnacle of denial which was reflected by investors' outright enthusiasm about stocks. At a time when approximately 8 of 10 investment advisors and newsletter writers were bullish on stocks, the ETF Profit Strategy Newsletter noted:

'The message conveyed by the composite bullishness is unmistakably bearish. The pieces are in place for a major decline.' Since April 26, the major indexes dropped as much as 17%. Despite the recent rally, this seems to have been only the first installment of a significant decline.

This decline is now in progress. In fact, the August issue of the ETF Profit Strategy Newsletter explains the one chart-pattern that explains why the next leg down will be strong and powerful.

A British Historian noted decades ago that a wise person does at once what a fool does at last. Both do the same thing; only at different times. Will you get out of the markets way in time, or too late?

Source http://finance.yahoo.com/news/More-Fuel-For-a-Bigger-etfguide-2250552826.html?x=0&.v=1