I find it interesting that markets are so driven by fear nowadays. I am, of course, speaking of the response of Lehman Brothers applying for Chapter 11. Perhaps this will be the event that will cause the US Stock Market to break down below the congestion range low at 1200.

The 2% to 4% world-wide sell-off surprised me. Lehman’s failure was, after all, not unexpected. The rumour mill has been working overtime proclaiming Lehman to be the next corporate victim. In his ‘Thinking Outside the Box”, John Mauldin published a piece entitiled: “Dead Men Walking”. That piece provided a model for identifying how a ‘good bank’ goes from a ‘good bank’ to a ‘Dead Man Walking’. The author, Bennett Sedecca, described Lehman Brothers as the ‘poster child’ for this sort of behaviour.

Since the Chapter 11 application can hardly be said to be an Act of God i.e. a bolt from the blue, it is either:

  1. the culmination of an unexpected event becoming visible or an
  2. over-reaction that may mark a temporary bottom.

There is a great deal of difference between the two; and I expect the first 60 minutes to 90 minutes to be the key to distinguishing between the two. If the event is (1), we’ll probably see an early rally but muted rally shortly after the open. By muted I mean a rally covering no more than 40% of the open-gap and preferably no more than 33%. Should the market not produce even a rally covering 25% of the gap, we’ll be seeing an even greater probability of (1) being the event.

If we are in (1), we’ll see after the first 90 minutes, a break of the lows on strong volume. Here Market Delta will prove invaluable. The rest of the day will be in trend mode down and we’ll see the ES down at 65 to 80 points (5% to 6%).

If (2) is the event, we can expect a rally covering at least 50% of the open gap in the first 60 minutes to 90 minutes. Following this period we’ll see the market make an attempt to form a reversal day. Given the size of the gap down, it is unlikely we’d see a close above Friday’s high but we ought to see a close above Friday’s close.

The readers of this blog will know that I lean towards (1) being the event in question. In all my public appearances, I have described my ideal scenario as being one where 1300 to 1328 is reached; this is followed by a test of 1200 to 1214 which gives way. A close with conviction below 1172 will confirm the start of the bear leg.

Take it easy out there and best of luck with your trading. Remember to plan the trade and trade the plan.

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