How Do You Catch a Falling Knife? Very Carefully

 | Sep 22, 2011 | 3:00 PM EDT
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In Tuesday's column, I wrote about how the rally into the midday highs had satisfied some upside objectives, notably returning the Dow Industrials to within five points of the mid-March lows and returning the SPX and S&P Futures to Monday's gap. I explained that the return to these levels was a sign of a possible near-term top, and it suggested selling at those levels. I wrote that I would sell at the close Tuesday if the market held its gains.

Did I know this would happen? I didn't have a clue. But I knew my targets were being hit and I was going to pare my holdings into that pop so that I would have plenty of dry powder to put to work in the event of another shakeout. And now a shakeout -- a very serious one -- is what we're getting. The Dow has collapsed almost 900 points from Tuesday's highs to this morning's lows. That's pretty serious.

What's more, the Dow has come within 80 points of its lows for the year. The iShares MSCI Emerging Markets ETF (EEM) is at new multi-year lows. So this is a major selloff. No big surprise -- I am viewing it as just another garden variety buying opportunity and nothing more.

That doesn't mean you can be cavalier about buying into this. To the contrary, when you are trying to catch a falling knife, you have to be careful. Pick your spots and add incrementally. The Dow has already given me a sign of where some of those spots might be. I was amused to see a headline on CNBC today that said, "Dow has now breached its August closing low of 10720." Well, that's one way of putting it. Here's another way: "The Dow has now filled its gap from August 11 at 10,720." The former suggests getting out of the way; the latter suggests buying. I am a buyer with the Dow at 10720 or lower.

DJIA: Backing off its mid-March highs to fill the Aug. 11 gap
Source: optionsXpress

Then there is the S&P 500 with its still partially unfilled gap from Aug. 11 at the 1121 level. The low so far has been 1124.92 -- about four points shy but maybe close enough for now. If that level gives, I will be looking for a further shakeout to the recent Aug. 9 lows for the year at the 0.382 retracement (at the 1101.73 level). If that level is seen anytime soon, I will be adding to my positions there.

SPX: Selling off toward the Aug. 11 gap at 1121
Source: optionsXpress

Arguing for a near-term low already in place is the chart of the Russell 2000 (although a one-minute chart would be more illustrative). Here, the morning low of 643 is just four points above the lows of Aug. 9 at 639.85. No big deal, the August lows held. But after the morning shakeout, everything bounced and then sold off to lower lows for the session in the Dow and SPX -- but not in the RUT. Its morning low held as the Dow and SPX sold off to lower lows. That's a minor non-confirmation that could signal the low for the move is in.

Russell 2000: Back to the August lows
Source: optionsXpress

My plan, depending on how soft the market is at the close, is to add to my longer-term positions at Fidelity, which I cut to only about 25% invested in late July. I'm willing to return to about 40% invested levels for the bigger picture, and I will add to modest holdings in the Emerging Markets Fund over there.

At Rydex, where I am back to a maximum of 60% invested, I will likely move to 70% invested for the Aggressive Growth Accounts. I'm only going up to 50% levels for the Market Timing Accounts. I am still holding bullish option positions and will continue to maintain them, taking some heat today.

The indicators are already improving. The McClellan Oscillator, which was slightly oversold yesterday at the -103 level, will no doubt be back to a fully oversold reading at today's close (assuming a close somewhere in this area). The sentiment picture is looking better, too, as the Volatility Index (VIX) pops back up into the 40s. That's music to my ears. The high so far today is 41.55, which is getting there.

VIX: Heating up into the 40s
Source: optionsXpress

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