The market experienced some dramatic plunges last week. The worst was the Dow’s intra day drop of 1000 points on 5/6/2010. I did not trade that day. But my TradeStation was open and I saw it. Initially, I thought it was a technical error from TradeStation. I immediately opened Interactive Brokers and Yahoo Finance. They all showed the same thing. While I was scratching my head, it pulled right back up in just a few minutes.
Now we know that it was caused by some glitches in the Exchanges’ electronic networks. On top of that, I believe machine trading contributed to it too. However, the market still lost 300+ points on Thursday, which has never happened since March 2009. What made it worse is that the market continued to drop on Friday(5/7/2010)
Before the crash, the market was in an extended overbought state. But Dow standing around 11000 does not necessarily mean it was overbought. Then what made it “overbought”? I think it was the continuous rally from 6000 in March 2009 to 11000 now. That rally had very few meaningful corrections. This is not good for the overall health of the market. The market needs constant corrections to inch higher in a healthy way. Let’s use 2 stocks as an example. One stock shoots up like a rocket. One moves forward 3 inches and then backward 1 inch. Which one do you think has more stamina provided the fundamentals are exactly the same?
The first stock will crash when it runs out of steam simply because there are many profitable people. Because people have massive profits on paper,they will sell it @ any price when they look for an exit, which will cause a big crash.
The second stock is a lot more stable than the first one. It moves a bit and takes a rest(consolidation or a small correction) during which it can shake off those who are not determined to tag along. This process is very important for a stock to continuously move higher without much resistance from the profitable sellers.
It is the same with the general market. A lot of funds(big money)have made massive profits on paper during this rally. They were just waiting for some kind of signals to unwind some of their large profitable positions. The euro zone crisis and the oil contamination were just triggers.
Personally, I do not think this is the start of a prolonged bear market like we had in 2008 and 2009. The overall fundamentals just do not support it. However, we might face a mid term correction here since this drop is big. We will perhaps see a few violent fluctuations in the next 1-2 weeks. If it bounces higher, It is a good opportunity to unwind some of your long positions. The worst at this stage is being fully loaded with net long positions. Remember you should always close your weakest positions first. Never average down.