Stock Market Bearish But Oversold

Looking at my weekend post, I was premature in predicting a commodity bounce, but on target with respect to action in equities. Last Thursday’s distribution day was a major sell signal for the primary indexes. Tuesday’s high volume selloff confirmed the market’s bearish orientation after the brief strength on Friday and Monday. I commented last week that the top was in for financials, and the cracks really started to show today, with big reversals across the board, and a huge drop for Lehman (LEH) shares.

Commodities and related equities also saw particularly heavy selling Tuesday, joining financials, housing, energy, and emerging markets. As we move further into oversold territory, it is worth considering prior bear phases to see what may be coming. Here is a chart of SPY (SPY) with earlier bear phases highlighted:

We could be in for a steep drop here, particularly in the financial sector, so long trades should be approached with extreme caution. At the same time, commodities and many equity sectors are oversold at this level, so short selling will be tricky unless we get a bounce into resistance.

Commodities are particularly oversold here. Bear markets can remain oversold as they head down, so a rebound is no sure thing. However, should we see buyers enter the commodity areas, a strong rally could develop quickly. Such a commodity rally is likely to place additional pressure on consumer sectors. Here is a chart of XLY (XLY), with today’s bearish engulfing pattern:

Considering today’s action in relation to the takeover of Fannie (FNM) and Freddie (FRE), we are seeing a very rapid reversion to bearish conditions after Monday’s short covering rally, and the government is running out of ammunition. Perhaps this time investors are realizing that such intervention brings no benefit to shareholders, or maybe the desperate circumstances are becoming more apparent.

I am lightly invested overnight, and looking to trade cautiously on Wednesday. Here are some potential opportunities for short sales:

- Johnson Controls (JCI) is still providing a good short entry.

- Sanderson Farms (SAFM) as well. Note the big gap down after recent earnings, and lower volume retracement to resistance.

- XLF (XLF): I will be more aggressively shorting financials once XLF drops below the 50 day moving average. XLF has very little support under the 19.75 area.

- Wachovia (WB): Up 12% yesterday, down over 14% today, on slightly decreasing volume. WB is a very whippy trader, so short positions need a tight stop or else a high level of patience. I think this stock will eventually see a Lehman-like decline, but the question is when. December puts are likely to pay off quite nicely.

- Overstock.com (OSTK) experienced a big drop after earnings in July. It has climbed on low volume, and looks stalled under the 50 day moving average.

- Delphi Financial Group (DFG): The declining 200 day moving average looks like significant resistance.

- Big Lots (BIG): Trouble getting over 35.00 on several occasions.

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