Panic Reaches Historic Levels

09/16/08 2:45 PM EST

As of: SPX 1251 HELP  ARCHIVE

The Panic Button that we've been discussing the past couple of days has moved again.  With the continued stress in the credit markets, heightened volatility levels and flight to "safe haven" Treasuries, Panic has moved up to 5.0, the kind of level we have seen only a handful of days since 1950:  05/28/62, 05/27/70, 08/17/82, 10/19/87, 08/20/07 and 03/19/08.

Over the next two days from those instances, the S&P was positive each time, averaging +5.5%, though most of them also came down to test or violate those lows.

We continue to be jerked around based on the latest AIG rumor, which is exceptionally important.  A confirmed bailout or help by the Fed should help us on the way to seeing one of those one- to three-day rallies that we typically get from these conditions...whether we'll get it without a confirmed message from the gov't, I'm not sure.

Still Working On Getting "There"

09/16/08 9:05 AM EST

Good Tuesday morning...We begin the day with another huge gap down in the pre-market futures as traders react to foreign-market fallout, earnings from one of the last securities firms standing (Goldman), continued rumors about AIG, Fed plans for more liquidity, and changing odds of an FOMC rate cut this afternoon.

Because equities are being rocked mostly by credit-related concerns, a big part of my focus has been on watching measures related to panic in the credit markets.  Bond traders are often thought of as the more intellectual brothers of stock traders, but that doesn't mean they don't let fear grip them just as much - or even more so.

A few months ago, we began looking at an indicator we dubbed the Panic Button, because it tends to spike very infrequently, but when it does it just goes crazy...like someone just pressed a, well, panic button.

Last Friday, I showed that it was only registering a reading of 1.0.  Historically that's a slightly elevated level, but recently it was perfectly normal.  That seemed very odd given the turmoil, and it left us wondering last week why there wasn't more panic.

Monday changed that, as we discussed throughout the day yesterday.  With the fall into the close and further deterioration in the credit markets, the indicator moved over 3.0.  With such a fluid situation, things will continue to change very rapidly but at the moment we are seeing more distress in certain parts of the debt markets, and the Panic Button is indicated to move above 4.0 this morning.

We're jumping ahead of ourselves, but we can take a look at historical movements above 4.0 and see how stocks reacted.

Like I mentioned yesterday, extremes in this indicator are not necessarily indicative of an imminent low, but it has been quite consistent in giving us a heads-up that we're in the endgame of the decline.  Since 1950, readings over 4.0 have led to a positive return in the S&P 500 63% of the time (48 out of 76 days), which is fine but no great shakes.  Where it gets interesting is when we look at the general dates of past occurrences:

May 1958:  A major low, S&P was up 17% over next six months.

April 1961:  Stocks chopped for several months, but up about 5% after six months.

May/June 1962:  Extreme short-term volatility, similar to after the '87 crash.  Stocks jumped several percent, then fell back over the next month before forming a bear-market low.

November 1963:  A major low, S&P was up 11% over next six months.

June 1965:  A major low, S&P was up 11% over next six months.

May 1970:  A major bear-market low, S&P was up 15% over next six months.

August 1971:  Kind of an odd reading, stocks rallied for a month, then fell back over the next few months before staging a major rally, S&P up 7% six months after initial reading.

August 1982:  The beginning of the great bull market, S&P up 37% over next six months.

October 1987:  Extreme short-term volatility, but S&P up 15% after six months.

October 1998:  Excellent short- and intermediate-term buy signal after the last financial crisis.  S&P up 42% six months later.

August 2007:  S&P up 10% over the next two months, but then rolls over.

March 2008:  S&P up 10% over the next two months, but then rolls over.

These are impressive precedents, and it's one of the main reasons I'm sticking to the odds that I laid out last week as to the most likely course ahead:  extreme short-term volatility with a downward skew lasting one to three weeks, then a major fourth-quarter rally.

Yesterday certainly helped along the first part of that roadmap, perhaps (but doubtfully) even fulfilling it.  I noted yesterday that the kind of breadth readings we got yesterday are exceptionally rare when coming after a prolonged decline, in fact it had happened only twice in the past 45 years (August 1966 and October 1987).

Certainly a 4% loss and a new yearly low is going to scare a lot of people.  But look at when it's happened in the past 50 years:

The four other times led to short-term volatility, for sure, but all were within a few weeks at most of a tradeable low.

With the gap down this morning, we really have few historical precedents.  I can find only four other dates since the inception of the index futures markets when the S&P 500 lost 3% or more in a day, then gapped down the next morning by 1.5% or more, as it's indicated to do this morning.  Those dates were 10/19/87, 10/28/97, 10/01/98 and 09/21/01.

All were in September or October, all led to extreme short-term volatility and all led to major intermediate- to long-term gains.

Based on the studies here and the ones we discussed last week, the pieces seem to be falling into place.  We have seen the extreme short-term volatility with a downward skew that generates true panic readings, and now we have the "puke" phase which should lead to a hammering out of the final low before a major rally into the fourth quarter.

For short-term traders, however, the path to get there is fraught with risk.  As we saw in 1987, we can still "crash" from conditions like these, and it does seem as though the hot-new-thing CDS market is akin to portfolio insurance from back in the day.  That makes me jittery about trying to buy into ever-declining prices, even though the probability of a vicious snapback seems so high.  But while the probability of a one- to three-day rally from a gap down such as this morning, the risk/reward isn't quite so positive.  You could win 9 times out of 10 taking such a trade, but that one loser could wipe you out if you don't use strict risk control.

My game plan from here is probably still going to involve doing nothing, and staying in cash at the moment.  I do believe this is the endgame for the decline, and in the intermediate- to long-term we're going to see good gains on the long side.  But I can't get a good feel for whether that starts today, or next week, or in early October.  It should be between now and then (I would now put that probability at 95%+), but the path to get to that low could and should be very volatile and could come from substantially lower prices.

There is no hurry for investors to try to get in at the very bottom, and unlike most of the lows of the past five years, I don't believe it's prudent to try to add long exposure into these declining prices...the risk is still just too high.  If and when the low forms, there will be plenty of time to take advantage.  It will seem disappointing when the indices rally 3% - 5% in a single session, which will almost certainly happen, but those short-term gains probably won't last and it will lead to better risk/reward situations for the rest of us.

Resolution to most of the major issues of the day will occur in the coming weeks.  AIG will get the capital it needs, probably via the private sector.  The banks that need to fail will fail, and that's being priced in as we speak.  The government will create some sort of trust to help with bad real estate loans, or some other solution as they scramble to stay (or get) into office.  It seems inconceivable that things will be OK, but tremendous pain has already been wrought, and it will pass.  I don't know if we'll still be higher a year from now, but I'm becoming more confident by the hour that we will be several months from now.