I still think the current “meltdown” is no more than a correction, as I always have. So actually, my stomach is not turning - though many stomachs are. The DOW has gone from over 14,000 to nearly 12,400, back over 13,400 and back down to almost 13,000. The move from the bottom of this swing to the recent high was about 1,000 points. Great events produce great volatility, so the volatility levels now should not be a surprise.

Now here is something interesting: a few weeks ago, in July, many people believed the same thing as me: that a market correction was due and even healthy in order for the bull to run a ways longer. Now, today, my view is the “contrarian” view, as many are now in full bear mode. But what is happening now is typical of asset (really, credit) bubble meltdowns.

No, Virginia, the stock market is not going to be fine. It isn’t. One of the largest credit bubbles in history is bursting, and while I don’t expect a full-blown recession to result, the end of the bull market certainly is approaching. I expect the market to regain the high above 14,000 and move to higher ground… for a while.

Not convinced? Consider these factors:

* Record retreat in housing sales for Q2
* Home prices are falling and are expected to continue to fall
* Car sales are hurting even worse
* We’re not close to the bottom of the subprime damage
* Housing woes will only accelerate unemployment
* Adjustable mortgage resets just in FEB/MAR of 2008 will be greater than in all of 2007
* Credit crunch is moving into other consumer debt categories, not just mortgages
* The credit card default rate is rising

I could go on… and on, and on. Bull markets are based on bull economies, it’s that simple. And the economy is deterioriating and will continue to do so. We’re headed for a “muddle-through” economy in economist John Mauldin’s words, maybe worse.

Why do I think the bull market is not over yet? Simple, the economy yet retains too much strength. Corporate earnings, the real bellwether for the market, so far have remained good, if not stellar. But I think the end is in sight. And the end will come when corporate earnings really start to deteriorate. In fact, the bull market’s end will come before that, since the market always leads the economy - that old insider knowledge at work.

And there is little the FED can do. Though some financial writers recently have been preening over how thoroughly the FED has potential dangers well in hand, it ain’t so. In fact, the FED’s hands are essentially tied. It cannot easily cut the FedFunds rate due to well-justified fears of the recessionary monster lurking in the rubble of the bursting credit bubble. And the FED’s announcement yesterday that it might not cut the FedFunds rate in September caused another sell-off. So the most the Fed will likely do, with inflationary fears genuinely looming, is perhaps cut the discount rate again or open up the “discount window” to borrowers other than hurting banks.

Besides, this is the same FED that in March 2007 didn’t expect the subprime problem to significantly affect the “broader economy.”

For those of you writing covered calls, I sincerely hope that you are buying back the calls when the stock moves down. If the stock is $55 and you write the 55 Call, for example, you should be repurchasing the call when the stock falls a few dollars. By closing the call at a price lower than you sold it, you make a profit. As the stock moves up and down, trade the short calls with it. In fact, some call writers in volatile times like to write ITM calls precisely so that the calls will lose maximum value when the stock pulls back.

Volatility has moved into the spare bedroom; you might as well make a few bucks off it.

Your faithful scribe has been out of town for a week, relaxing a bit. The DOW closed at a low of 12,455 while I was gone, down 1,666 from the 14,121 high (11.8%). You don’t have to be religious for those three sixes to bother you. The DOW closed today at 13,121, almost exactly 1,000 points from the high. The SPX is down a like amount. The question we’re all asking, like kids in the back seat on vacation, is “are we there yet?” Can we breathe safe in the assumption that this substantial pullback is merely a correction?

Another view was called to my attention today. In recent history, there were two previous credit crises: 1990 and 1998. In both of them, “the late August peak in the S&P 500 and the near-term low in the VIX occurred on the 23rd trading day from the 52-week high of the S&P 500 set that July. Both times, the market had already sold off more than 9% and then rallied at least 1.5% by the close on the 23rd trading day; yet, by the end of August, the S&P 500 was down an additional 9% to 12%. Today, Monday, August 20, 2007, is the 23rd trading day since the S&P 500 set a high on July 19, 2007. So, if history repeats itself, today is the day to short the market.” - EarningsWhispers.com.

Interesting, since the market has popped up more than 2.5% from the bottom last week. The current credit crisis is not identical to the two earlier ones (in particular, the Fed has acted much more quickly), but IS eerily similar in some ways - particularly how the VIX, a measure of investor fear, behaved both then and now.

The Fed cut the discount rate (not the fed funds rate) as a sop to the market, and - this is a biggie - has revised its earlier stance that the subprime issue is not expected to have major effects on the broader economy. The correction may not have bottomed, and revisiting the lows from last Thursday or even going lower is a distinct possibility as bad news piles upon more bad news. The market is very jittery now, and many are pulling the trigger whenever the bushes twitch. It doesn’t take much to send the market spiraling down.

I still think the sounder view is that the market is correcting. The puncturing of the credit bubble may not yet have progressed far enough to end the bull market; it’s impossible to tell. But the sight of central banks injecting nearly $300 billion into the world’s monetary supply is NOT an encouraging sign.

Yet I still think the bull has legs, primarily because corporate earnings remain strong, and I think that weakening earnings ultimately will be what sends the bull over the cliff. Remember, the market came back from the debacle in 1998 to new highs before the final crash in 2000. So I think there is reason for encouragement. Yes, I think we’re in the end game for the bull market, but the bull has further to run. But there may be rough water ahead in coming weeks, if history is any guide. If this crisis takes the same course as the two last ones, we could have a lot further to fall.

If the market appears to be taking a dive again, consider buying multi-month ATM puts to protect open covered call positions, assuming you have not already done so. If the dip is short-lived, you can sell the puts and recoup your cash, perhaps at a profit. If there is an additional sell-off, you can sell the puts for a very nice gain and hold the stock, or simply exercise the puts and sell the stock. The puts place you in the driver’s seat. It is late in the day to buy puts, considering how far the market has fallen, but ’tis better than simply watching them go down.

I would be loath to dump good stocks that are down, particularly large caps, since they will come back when, and if, the correction resolves itself. Buying puts is a way to delay having to decide whether to take a loss or hold the stock and takes the pressure off.

In my post this morning, I speculated that the correction was not over yet and that the bottom was yet to come. Chicken Little is running full tilt this afternoon, but the market is what it is, and I for one doubt there is reason yet to conclude the bear is here.

Well, the correction is clearly not over yet, with the DJIA losing 387 points today (2.8%). But for me, that’s in the so-what category, since I simply think the correction continues to progress.

The sub-prime mortgage mess just gets worse all the time, as I have been predicting all along, because I have thought since at least February that it is far worse than most all financial commenters believe it to be. In an earlier post I noted that all true stock bubble markets are really asset bubbles, and at bottom, credit bubbles. Now the subprime crisis is making its way up the food chain. As long as the damage was mostly confined to hedge funds and subprime lenders, no one got too concerned; the Fed Open Market Committee seemingly least of all. The FOMC remains far more concerned about core inflation. Now major European central banks are finding it necessary to inject huge amounts of liquidity into the financial markets. Here is a great quote:

“Subprime problems have now gone global,” said Kathy Lien, chief strategist of DailyFX.com. The damage “is no longer limited to just small banks and mortgage lenders, but is now hitting Tier 1 banks around the world.” This is the asset (credit) bubble stretching at the seams before bursting open.

I have always thought the puncturing of the asset bubble would eventually undo the bull market, and it will. You hear a lot about the yen carry trade (borrowing in low-interest yen to take advantage of higher interest opportunities elsewhere). Well a lot of the yen carry loans went into - you guessed it - the asset bubble. The problem is gargantuan, and it’s global.

There are many bulls out there, including some (like Gerald Appel, the MACD inventor) whose opinion I deeply respect. And I think the bulls are right to say that this great market is not over yet. They point to corporate earnings holding up well so far and similar encouraging factors. But the fractures are obvious from so many signs. And when earnings start to tank, so will the market. Consumer spending drives corporate earnings, and since Americans don’t save and spending the last few years was driven by cash obtained from hone equity withdrawals (a tap mostly now shut), where will the spending come from? In fact, the market may start to tank well in advance of lousy earnings, since it tends to lead economic swings by months.

I hope this correction underlines for readers why I harp so much on confining covered call writing to the best companies. Yes, 25 of the 30 DOW stocks were down today, but that means 5 weren’t. When the market starts digging out of this correction, the best stocks will come back the most, and fastest. And when the bear comes, the best large-cap stocks will hold up the best and the longest.

I won’t repeat in detail here my many exhortations for covered call writers to take advantage of volatility swings in the market or to consider the purchase of multi-month puts. But are you rolling the calls down and writing ITM calls as the stocks drop? This captures some of the drop and puts it into your pocket.

Like the corner man says to the boxer, protect yourself.

Yesterday (Wed. Aug. 6th) it seemed to some that the market was bouncing back quickly this week to regain territory lost since the sell-off that began on July 20th and reclaim the 14,000 DOW crown. But not so fast. Corrections take time to resolve. A “real” correction usually will take a month or more. Hence it is no surprise that this morning the market is down. This correction simply ain’t over yet, pard. That’s why we’re seeing so much instability and triple-digit up and down days.

So, what is a “real” correction? It’s one that reaches a classic fibonacci retracement level and that everyone afterwords believes to have actually been a correction. The reason is: that belief is the key to humans committing to actions that take the market to new highs. We’re getting into psychology a bit here, where angels fear to tread; but since it is humans (for the most part) who trade and therefore create bull and bear markets in the first place, psychology is very important. Imagine a 50% retracement that resolved from top back to top in three days. Though a classic fibonacci level was hit, would enough people believe that a correction had occurred and resolved to act upon it? I think the answer is NO; only the most optimistic could believe it. And if unconvinced, everyone continues to wait for the “real” correction instead of committing more money. This lack of support eventually results in the correction reaching the final stages.

A correction that resolved in a week or two would therefore not be terribly convincing. As Exhibit 1, your honor, I submit the earlier 441-point market dip in June of this year. It simply was not as large as it should have been and resolved far too soon (two weeks)… for a “real” correction. And rather obviously, nobody believed that it was the real thing, else we would not be having the current one.

Look at the correction in Feb/March of this year, by contrast, in which it took 6 weeks to regain the lost territory. Since the reason that corrections work and allow markets to go higher is rooted in human psychology, a correction is “real” only if it is large enough and unfolds slowly enough to command respect.

We’re 20 calendar days or so into this correction, which has been far more volatile than the one from March, comparing candle sizes. If I am not very much mistaken, there is more to go, perhaps weeks, with big swing days, until a resolution finally occurs. I think that resolution will be a temporary continuation of the bull, but whether that occurs and how long the bull can then run is anybody’s guess. Be that as it may, I don’t think we’ve seen the bottom of this correction.

TRADING THOUGHTS:
Those of you who still have covered call positions open now (bless you) should be trading the calls as the stock moves. When it pulls back, close the call, rewriting it when the stock moves back up. Rather than being intimidated - or scared plumb out of the game - by this correction, trade it.

As always, if you fear the bear market has already begun, buy a multi-month put, as discussed in prior blog posts.

A column of Jim Lowell’s on Marketwatch was entitled “Beach Blanket Bingo” - suggesting that investors could perk up the summer doldrums with foreign small-cap companies (actually, ETFs). I don’t mean to pick on Lowell, but in the decaying stages of a bull market, which is where the market now is, it is the large caps that perform best. A number of financial writers suggest that the place to be now is with blue chips, and I concur absolutely. Here’s why…

The trajectory of a bull market looks like this: small stocks ignite bull markets, then the mediums come in, and the large caps take off latest of all. In fact, when large caps ignite and start performing well, the smaller- and medium-cap stocks are not doing so well typically, a result of the flight-to-quality syndrome. This was best illustrated in the March 2007 correction, in which the blue chips fared best and recovered the fastest (if they even took a hit at all), precisely because of the flight out of smaller- and medium-sized companies into large caps - in other words, quality. When we start reading in the financial press that blue chips are outperforming all the sassy young companies, it is clear that the end of the bull market is in sight. Perhaps not imminent, but in sight. This behavior is not a bad thing, merely a sign of the end times for a bull market, make no mistake.

Lowell is definitely out of step with other financial writers at this point. Michael Kahn, for instance, suggests that the dollar is rising as a result of - not causing - mounting danger in the financial markets, and the cure is to stick with blue chips. Doug Sander of Wachovia: stocks will move higher in coming months due to growth in large-caps. Brian Belski of M. Lynch is promoting large-cap healthcare and consumer staples, which though lacking “exciting numbers” are nonetheless “strong and consistent growers” - they are necessities and not linked to employment and economic trends.

Now, there’s a glowing endorsement of a bull market, if you’ll excuse my sarcasm. It actually is good advice, though: stick with companies that in coming times might actually make money, even if not a whole lot. Kingman Penniman of KDP Investment Advisors says investors may have to refocus now on earnings and revenue. Well, THAT’s a sure sign of an exploding bull market, hmmm? Wrong. We’re hearing this same refrain everywhere: things are a little shaky and uncertain, so move to quality. Partly because quality is where the RETURNS are, but as much or more so because that is where SAFETY is. While no stock is ever truly “safe,” relatively speaking, the blue-chippers are “safer” now.

OK, you covered call writers, forget the beach blanket bingo and heed the smoke signals. The safest stocks to be in now are the large caps that are growing earnings or at least maintaining healthy profitability. In healthcare, be cautious of pharmaceuticals and stick with the largest and most profitable of them if you write the pharmas.

Stocks are down now as the market corrects. August is normally a dull month, but by late August we should see a rebound in the market, if indeed this sell-off is only a correction. If you had calls written on stocks that are down now, this could be a great time to buy back those calls to clear the decks. Be careful about writing stocks at a lower strike that are down now, since you may be trapped in that too-low call strike if they rebound with the market.

Those of you who bought protective puts at a higher level: it is not time yet to sell the puts, since the market seems disinclined to hang onto the 13,200 level - support in the June pullback was 13,251. Wait to sell the puts until we have a decisive bottom and recovery.