Friday saw further erosion in the equity indices. The S&P 500 closed at 1387 which was more or less on its low for the day. Over the course of the week the S&P 500 cash index (^SPC) lost 4.4%, the Russell 2000 (^RUT) fell 6.2% and the broker/dealer index (^XBD) lost 7.6%.

We are about to find out whether we are seeing just a healthy correction that was overdue given the market's bullishness throughout the last several months or a far more serious example of the kind of contagion that has arisen from the inter-linked risk taking practiced by the financial engineers that mastermind so many asset management companies.

The Goldilocks scenario that has encouraged fund managers to accept low rewards for speculation in asset classes that have traditionally commanded higher risk premiums could have gone into reverse. To cite just one example of a miscalculation of the inherent risk in certain asset classes, HSBC is ready to write off about $11 billion of assets in the light of its exposure to the US mortgage markets.

We may be wrong in sensing that there is more bad news to emerge but we do see strong support on the S&P 500 at 1280 and it would not surprise us to see this level tested before this contagion episode is over.



The Nikkei 225 (^N225) fell by 3.3% in Monday's trading. As the chart shows the intraday low coincides almost precisely with two vital chart levels. The first is the rising trendline through the lows that date back to the recovery in June 2006 from the last financial contagion episode. The second coincidence is that the intraday low is very close to the 200-day EMA. Notably the index failed to find support at the 16800 level which marked the low from early 2007.If the Nikkei fails to respect the support at current levels the chart would look even more bearish than it does as of today's close.

The rise in the Japanese yen continued during Tokyo trading as large funds continue to exit the carry trade. As we commented last week the single largest contributory factor to the recent market malaise is a major re-appraisal by funds that are predicated on financial engineering of the risk associated with burgeoning financial liquidity. Just how much further unwinding of synthetic instruments will take place remains to be seen but this is of far more gravity to market participants than the usual chorus of cheerleaders stressing how good the market fundamentals are.



The weekly chart for the CBOE Volatility index (^VIX) shows that we closed at the highest weekly close over the last two years and really since the market staked out its recovery from the bubble years. On Tuesday the index recorded a 64% overnight increase in terms of the perception of market risk which is hard to reconcile with so much economic theory that assumes that markets are allocation mechanisms that are based on the interaction of agents acting rationally.

The previous risk/liquidity scares occurred in connection with the GM/Ford convertible arbitrage scare of 2005 and the more amorphous May/June 2006 episode. Indeed one of the more unsettling elements of the current turbulence is that it is just as difficult to point to the trigger for the current waves of selling in terms of economic fundamentals as it was in May 2006. Rather we are witnessing a case of the purely "financial economy" operating according to its own logic and dynamics.



TRADE OPPORTUNITIES/SETUPS FOR MONDAY MARCH 5, 2007

The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions. None of these setups should be seen as specifically opportune for the current trading session.

We hesitate to make any individual recommendations today as the macro conditions are so unstable that the chart patterns are less reliable than usual. We would caution that both of our setups need to include the qualification that they should only be taken as meaningful if the market gains some stability during the coming sessions. Nutrisystem (NTRI) has some indications that it could be completing a basing pattern.



Chesapeake (CHK) has some indications that it was poised to move higher but there may be short term pressures on the energy sector because of concerns that world consumption will decline if we are heading into a downturn.



Clive Corcoran is the publisher of TradeWithForm.com, which provides daily analysis and commentary on the US stock market. He specializes in market neutral investing and and is currently working on a book about the benefits of trading with long/short strategies, which is scheduled for publication later this year.

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