In February I did a simulation of the market. And if you look at how I predicted things, it has turned out to be pretty much on the money. My tops and bottoms are not completely right in terms of values, but pretty close. Closer than I expected.

Along comes RBS and says the following.

A credit strategist from the Royal Bank of Scotland warned investors in a note that the S&P 500 may fall by more than 300 points by September and that iTraxx index of high-grade corporate bonds could soar, according to a report in the Daily Telegraph newspaper. “Cash is the key safe haven. This is about not losing your money, and not losing your job,” the RBS strategist, Bob Janjuah, was quoted as saying.

So I decided to do an update on my simulation and see where the chips may fall so to speak. Since the beginning of the year I have tuned and updated my analysis on the market, and it includes the data from 1950 to now. This means I do have the big crashes of 1970, 1987, and 2000 in the system.

First could the market drop to say 1000 for the S&P? From the simulations yes it is possible. The correlation says it is a strong match. HOWEVER, I have other conditions that say, no that would be an event of greater magnitude than 1970, 1987, and year 2000.

Are we in a situation that is worse than 1970, 1987, and 2000? No, but there is something else that could be happening. What if the shorts start to short the heck out of the market? Could we see a collapse? Absolutely!

What makes me hesitant is that there is a slight difference in the market. From the data the year 2000 pullback was the worst in since 1950. Thus I think a comparison to that time would be appropriate.


The top graph is now, and the bottom graph is year 2000. Notice how both trended in a channel. BUT, look at the location of the black arrows. Those are about the same time period in relation to the stock market correction. In the year 2000 that moment was an extreme collapse. Yet now that period was not an extreme collapse, it was a range. It is that time period that is changing the boundaries in my simulation. Notice in the upper graph that the sell off was very strong, and then was abruptly stopped.

When was that moment? It was when the Fed stepped in and saved Bear Sterns. At that point we had a solid, but slow rally. In contrast, for 2000 that rally was very sharp and swift, only to collapse again. Whenever I run the simulations it is that consolidation that is causing a complete breakdown of the market.

But there is something else going on, and why I think that the market will not collapse. As I write this CNBC did a profile on the investing habits of portfolio managers. What they found out is an extreme divergence where portfolio managers were completely overweight in the sectors transports, energy, and commodities. In everything else they were completely underweight. This is odd and very extreme.

When the market recovers it will be a slow recovery on the S&P because those leading sectors will be lagging, and the lagging will be leading. For the market to completely collapse all sectors will have to collapse, but that is simply not possible from a valuation perspective. Outside of techs such as Apple and RIM most companies like Nokia, TomTom, and Garmin are trading in reduced EPS single digit range. That is an extremely oversold situation. We are oversold because there is an extreme number of shorts on those companies that is driving the price down, down and further down.

And the last thing that makes me skeptical is that the emerging world is still growing and moving forward. That’s why I think RBS is completely wrong.