The first major rupture for the current correction was felt on Tuesday February 27 and two weeks later also on a Tuesday there was another big rupture - whether it was an aftershock or a new fault line emerging remains to be seen. It is our firm view that this correction is about a re-appraisal or re-pricing of risk in the financial sector rather than a worry about an impending recession or concerns about earnings. Not to say that these will not become larger concerns if the ratcheting down of leverage in the financial sector begins to accelerate.

The correction has a lot of similarity with the May/June 2006 correction. The cynic might say that it's worst this time since hedge funds have even more assets in their portfolio this time around where the risks to those assets are more severe than they thought. This raises the question of how risk can be accurately priced. One of the innovations of the Michael Milken era was the notion that in the credit markets all risk can be measured and then priced appropriately. If a financial institution has an appetite for risky investments it can purchase high yield bonds where the yield spread provides the reward for the higher risk. But in the sub-prime sector it would seem that no reward could be devised that was sufficient to compensate for the risks that unqualified borrowers would all run into difficulties at the same time. The possibility that such risks cannot be properly assessed since there is no marginal ability to pay - you either make the payments or you don't - there is no graduation of credit worthiness - suggests that pricing such credits was misconceived.

The chart for the banking sector (^BKX) which covers the money center banks is the one that causes us the most concern from yesterday's trading. While the broker/dealer index also had a bad day the plight of the large mainstream banks is a more critical to the credit markets. If the financial engineers have been mis-pricing risk and if there are further big surprises to come - perhaps from the high yield market or the CDO market - then we could be in for some nasty surprises ahead.



The S&P 500 index (^SPC) dropped two percent but notably managed to close above the lows from March 5 and 6. We should expect the levels from those previous sessions - around 1374 - to be tested today and if we pass straight through them we are probably headed much lower. Two weeks ago we raised the possibility that the S&P 500 will test a major support area around the 1280 level before this correction is over and after yesterday's developments we feel that this scenario is now more probable.

One thing that was apparent in yesterday's market action was the correlation between movements in the currency markets and the selling waves that hit the major indices. Watching the GBP/JPY cross rate in particular showed that the weakening of the higher yielding currency coincided with the biggest drops. In particular the big drop in the cross rate as it fell below 225 when the London markets were closing saw support levels taken out on the S&P 500 and damage being down to the large financial stocks. Given that many of the largest hedge funds are based in the UK this suggests that watching this cross rate in coming days could provide useful clues as to how much further selling we will see.



The broker/dealer sector (^XBD) closed just below the 225 level yesterday which puts it below the intraday lows from March 5 and 6 and back below the 200-day EMA. As we discussed above this correction is mainly focused on the financial sector and the importance of the XBD cannot be overstated in terms of understanding the US economy which is now a financial services economy rather than a manufacturing or hard goods economy.

Just how vulnerable the large investment banks are to problems in the derivatives markets is the real enigma of the current market conditions. Many analysts of the sector and those within the investment banks are downplaying the concerns but the cynic would counter that they would say that wouldn’t they. We suspect that the mis-pricing of risk that has taken place because of the ubiquity of liquidity has further ramifications than we’re seeing in the sub-prime mortgage sector.



In Wednesday's trading the Nikkei 225 reacted to Tuesday's sell-off in the US markets with a 3.6% sell off. The index gapped down substantially on the open and closed near to the session's low but as with many of the US indices the close was still above the finishing level of March 5th. One of the specific variables that makes the export driven Japanese market more sensitive is the level of the yen against other major currencies which links back to the carry trade issue.



TRADE OPPORTUNITIES/SETUPS FOR WEDNESDAY MARCH 14, 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.

The CBOE Volatility index (^VIX) spiked back above 18 yesterday but the reading is still below the extreme levels near to 24 that were seen in the May/June 2006 correction.



The Treasury market has performed a major reversal since last Friday. The employment report caused an upward surge in yields which over the last two sessions has been completely reversed and suggests now that the 4.4% level which is an area of long term chart support will be tested.



The chart for Citigroup (C) highlights the market's concerns with the major money center banks. We have indicated on the chart the threshold level which would be required to cross to move back above the trendline through the lows and this should now present a major line of resistance. Just how much lower we could go is not clear from the chart but last July's level just above $45 could well be in play.



Despite a very strong earnings statement Goldman Sachs (GS) succumbed to selling. However in general terms the GS chart looks relatively far stronger than many of its investment bank rivals - such as LEH, MS and BSC which we review below.



Bear Stearns (BSC) dropped by more than six percent in yesterday's trading which is an uncharacteristically large move for a front line financial services company.



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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