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Saturday, August 11, 2007

A step closer to correction

Last week I wrote a post where I took the position that stocks were headed for a correction and that we were nearly there. I haven't seen anything this week that would change my mind.

Even though the major averages managed to end this week a bit higher than last week, I find it hard to be optimistic. The markets started the week off moving upwards nicely but took a pounding on Thursday that nearly erased the previous days gains. We were incredibly lucky to see the averages close with only small losses on Friday after starting the day off with downward gaps.

This week central banks around the world injected cash into their banking systems in an effort to keep credit markets functioning. CDOs backed by sub-prime mortgages have been blamed in England, Germany, France and Australia for hedge fund problems. It is amazing to me that so much sub-prime debt even exists and is held by investors in so many different countries.

Charts continue to look awful. In an interesting divergence, we see that the S&P 500 closed right at its 200-day moving average but the SPDR ETF (SPY) actually closed below its 200-day (and for the second time). The Russell 2000 finished the week in a confusing manner with the MACD starting to turn up but with the 20-day moving average making a bearish crossover to move below the 200-day. The Russell 2000 remains about 2% below its 200-day MA which is considered definite bearish territory.

The major averages are pretty much all off their highs about 6% so we are more than halfway to the 10% mark that commonly defines a correction.

What worries me about the current situation is that problems in other countries are impacting markets in the US and vice versa. This is not unusual in today's financial markets but the linkage this week seemed especially telling. It goes without saying that it is hard enough to predict the direction of local markets without global impacts to worry about.

The wakeup call from this week's market action is that the financial problems we have been grappling with in the US are now rippling across the world. As new financial instruments have been used to spread risk across many investors, we now see larger numbers of investors beginning to feel pain all at the same time. If they all decide to sell at the same time or, worse yet, many of them have to sell at the same time, we could see markets tumbling like dominoes. I don't really expect that kind of disaster but, as noted above, we are only a few percentage points away from a correction. And that correction seems rather likely now.

By the way, I notice that we don't have so many pundits saying sub-prime problems are "contained" and that the "contagion" won't spread.

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