-This is strictly a guess, but I think many of the current quant fund problems and their all-to-simple excuses about markets not acting “normally” are akin to a group of poker players trying to hide a losing hand.  The real problem, I’m guessing, was created by a massive margin-driven liquidity squeeze that forced trade executions having nothing to do with the buy or sell triggers built into their quant models in the first place.  The decline seems too shallow to warrant excuses about not expecting “a correction” or markets not acting “normally” especially given the fact that this decline, so far, has been historically shallow and the VIX has only registered an intraday high of (29.84)!   Take a look at how that stacks up against VIX spikes during other periods of panic and you can see that we’re way too early in this decline to be blaming things on the computers.

VIX Intraday Highs During Market Declines or Panics

August of 2002 (45.08)

September of 2001 (43.74)

October of 1998 (45.74)

October of 1997 (38.20)

NOTE: We think the VIX will spike to at least 36.00-37 over the coming weeks.

-Contrary to popular belief, Market crashes DO NOT happen out of the blue.  They are events that only occur after the proper emotional set up is created and that set-up normally takes several months or weeks to form.  The fact most people miss—even some technical analysts I’ve heard speak—is that crashes, although rare, can occur off the highest high within an uptrend as opposed to the more common crash which occurs off a failing rally high within the early stages of a downtrend.

-When RSI is setting up for a potential crash it acts in a very specific manner.  Remember, crash set-ups NEVER predict that the crash will happen, they only warn us that conditions are proper for the crash to take place and that if the market is “pushed off the cliff” the fall will be fast and deep as opposed to fast and shallow.  Markets can always get whacked to the downside under almost any configuration of RSI but without the proper configuration they cannot crash.  (It’s simply a mathematical impossibility)  The easiest way to understand it is to think of the market (any market) as always walking along a ledge but whereas most of the time the ledge is only 5 feet above the ground, a crash set up warns us that the ledge is temporarily 50 feet above the ground and that if the market were to slip off the ledge, the fall would be very painful—if you’re long. 

-FACT:  The most bullish moves occur after a market becomes “overbought” and the most bearish moves occur after a market becomes “oversold.” I always cringe when the talking heads speak in terms of overbought or oversold, because what they fail to understand is that those terms are worthless—in fact they’re very dangerous—unless you understand where market price lies with relation to the overbought or oversold reading.

Extreme overbought RSI readings, when they’re reversing off a period of sustained decline, are actually very bullish whereas extreme overbought readings moving into a high after a sustained advance are (immediately or eventually) bearish.  The same is true when moving in the other direction, in other words extreme oversold RSI readings, when they’re reversing off a period of sustained advance—as is the case currently–are actually very BEARISH whereas extreme oversold readings moving into a low after a sustained decline are bullish.

But the most bearish of all (I’ll speak in terms of bearish set-ups only for purposes of helping you understand why I’m so bearish currently) is when a market declines sharply in price with the RSI holding near the 35-38 level—as opposed to getting hammered down to or through the 30 level— then rebounding to the 40-51 level before reversing again below 35-38.  That set-up is the kiss of death because the slight blip up to the 50 level after the first trip down allows the market to gather even more downside momentum for the next leg down.  In real-life terms the bounce that allows the RSI to lift to the 40-50 level is a signal that shorts are covering and that bottom fishing is taking place which in turn leaves a new group of potential sellers down near the lows.    

As far as determining whether you’re in a sustained advance or a sustained decline, that’s something specific to each time frame we track and the model’s topping and bottoming counts answer that question very nicely for us.  Today’s set up however, is very obvious since we’ve been in a sustained advance since the 2002 lows which means the current RSI set-up is coming off a top.  Again, this is very bearish.

I know this sounds over-confident but the advantage I have here is in following the BAM model’s dynamic of “fractal” market movements, meaning that markets act in the exact same manner whether you’re studying a 1min, 5min, hourly, daily, weekly or monthly price bar along with its RSI movement.   What this means, is that I’ve seen and studied every type of emotional set-up you can imagine as they unfold in intraday set-ups 10’s and 100’s of times each and every week.  In other words I have, in essence, studied thousands of year’s worth of daily and weekly market movements through my study of 1 minute, 5 minute, and hourly bars.  A one minute bar is equal to a one year bar…so you can do the math.   Anyway, today’s current RSI configuration is potentially very bearish (read crash bearish) so we’ll be keeping a close eye on it for all of you.

Full report coming soon