When I posted the article yesterday morning asking if 2011 was like 2008 or 2010, I had no idea we would endure the worst day since 2008.  As the market cascaded lower throughout the day it certainly felt like 2008 and brought back haunting memories of the time where we wondered whether or not the U.S. financial system was going to survive.

Before we know where we're going, we first need to know where we've been.

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What happened on Thursday?

Yesterday was one of those days where you just couldn't find good news.  Consider all the market had to deal with:

1. Japan launched a massive intervention against the Yen, trying to weaken it against other currencies.  This follows the intervention by Switzerland the day before against the Franc.  Last September I discussed why countries actually prefer a weaker currency (as long as it's not too weak.)  Looking back at that article, I notice that the dollar has fallen 6% since last September.  More on that later.
2. The European Central Bank announced their own version of quantitative easing and immediately began purchasing bonds in the open market.  The problem was they purchased Portugal's bonds rather than Spain's or Italy's -- the two countries that appear to be on the verge of needing a bailout.  We already know that the EU has chosen to go down with the ship.  The big question is, "who will bail out the ECB?"
3. Both Italy's and France's markets crashed -- not in price (although both were down over 4%).  Their computer systems crashed and stopped reporting index prices causing widespread fear.  We already know that Europe is essentially broke, so the fact that their computer systems also broke shouldn't be a surprise.
4. Rumors were circulating that there was an electronic run happening at the Italian banks and overall liquidity seemed to freeze late Thursday afternoon across Europe.
5. Bank of New York-Melon sent shockwaves through the credit markets early in the day when they announced they would begin charging fees for cash deposits in excess of a clients' "normal" cash balances.
6. Traders were also dealing with questions about what large banks have too much exposure to the bad European debt, via direct investments, loans, or worse, Credit Default Swaps.  Everyone is worried that nobody learned from 2008 and are repeating the same mistakes that caused that crisis.
7. Traders have been saying for a few weeks that many hedge funds are on the verge of failure.  Remember, hedge funds were the primary driver behind the big rise in the market at the end of June.
8. The dreaded Margin Clerks began making their afternoon calls, causing nearly every asset (including precious metals) to see their losses accelerate.  As usual, the use of margin (borrowing money to purchase stocks) accelerated as the market rallied off the June lows.

How did we get here?

It's not like we got here overnight.  Regular visitors to our site knew what the market is just now realizing -- everything is not as great as investors thought.  Here's what is now on their mind:

1.  The economic data the past week has been downright awful and is causing people to reconsider the conventional wisdom that the weakness in the spring was "transitory".
2. The debt ceiling circus highlighted three things -- 1) Congress continues to kick the can down the road without worrying about long-term ramifications, 2) the debt ceiling deal actually creates massive uncertainty as Congress tries to decide how to actually come up with $1.5 Trillion of spending cuts (or revenue increases), and 3) the size of the cuts are small in the whole scheme of things and pretty much assured everyone that we will eventually lose our AAA credit rating.
3. The longer the economy continues to struggle even with the Fed printing money and the government running trillion dollar deficits, the more people realize that there are real STRUCTURAL problems with our economy.  
4. The Grand Experiment appears to be failing.
5. The fear that Greece = Bear and Spain/Italy = Lehman is inching closer to becoming a reality.  There simply isn't enough money in the world to handle all of the bad loans that were made during the housing bubble and it WILL lead to further financial chaos.
6. The longer this weakness continues, the more the "d" word enters investors minds.  I first discussed this in July 2009 when I called the end of the recession.  I warned at that time that Depression was a concern.  Remember, the definition of depression is a period during which business, employment, and stock market values decline severely or remain at a very low level of activity.  I wrote at that time, "Unless the job market improves we are destined for a real Depression.  Today's unemployment report really doesn't change my opinion.
7. There is a major disconnect between Wall Street and Main Street.  Remember when I asked, "which one of these does not belong?"  The thing that jumped out at me was the lack of growth in real disposable income.  It is tracking the worst recovery on record.  I saw this chart the other day that really highlights the struggles on Main Street.

So are we doomed?

All of these problems do not mean that the market is going to head straight down.  It could in fact go higher for many reasons:

1. Yesterday smelled of capitulation.  The VIX (fear indicator) jumped nearly 33% and closed the day over 30.  Volume accelerated and the market is heavily oversold.  Based on the phone calls to our office and from talking to other advisers many people "puked" yesterday and sold everything.  With an absence of sellers, the market could see a nice bounce. 
2. Earnings growth this quarter has actually been quite strong. One thing the Fed's policies have done is allow stronger companies to refinance their debt at much lower rates.  The weaker dollar has also helped multi-national companies as it makes their goods cheaper overseas.  Unfortunately, the higher earnings have not meant an increase in jobs.
3. This could still end up being "just a soft patch" in the economy.  If so, all of those people that went short the market or sold their stocks banking on another recession will likely become buyers once again if the economic data turns around.
4. Tech continues to be a standout in terms of potential strength in our economy.  For those of you that think I can only write negative things, I'd encourage you to take a look at these two articles discussing one area that can lift the entire market/economy:  Reason to Be Bullish   /  Signs of Strength
5. Many people believe (myself included) that the Fed will announce as soon as their meeting next week the next iteration of Quantitative Easing.  The Fed Chairman has no other strategies than to print money and will continue to do so until he is fired or the credit markets punish the dollar so much that he cannot continue.  He is either a liar or is incompetent, but that doesn't mean that he can't give a nice boost to the market once again.

What about QE3?

I saw this chart yesterday on dshort.com and it said that QE3 was all but certain due to the drop in stock prices.

One thing that I noticed was that while the Fed said the purpose of QE was to lower interest rates and increase liquidity, rates actually rose during their money printing periods.  As we've pointed out all along with our Fed Balance Sheet chart, the problem is not a lack of money, it is the lack of banks willing to part with the money the Fed is printing that is the problem.

If the Fed wants to stop shooting blanks it will figure out how to get the money out of the hands of Wall Street banks and into the hands of people that will actually create jobs and stimulate growth. 

What do the charts say?

Once again, some serious technical damage was done yesterday.  I've drawn some line where the market could possible stop falling and/or where it may run into problems.  Remember, these are levels where a lot people either sold or bought and once you get back to that level they may be inclined to do the opposite.  How many times have we said, "if I just get back to breakeven I'll sell," or "if the market gets back to ____ I'm going to buy this time."  That is why technical analysis works most of the time and why past support becomes future resistance and vis-a-versa.

The chart of the NASDAQ (tech stocks) actually looks much healthier than the S&P 500.  It could easily jump back up above the breakdown point.  The big worry though is that there isn't much support below where it is at right now.

The market may use the payroll report as an excuse to rally.  Thankfully it wasn't a bad number or we could have seen a crash today.

How did SEM react yesterday?

We actually didn't have too many trades to place.  Most of our systems had already gotten bullish.  Here is where we stand and the moves we made yesterday:

• Income Allocator (INA):  Sold over half of our remaining high yield bond (HYB) exposure.  That leaves us at: 18% HYB, 12% "Alternative" Bonds (convertibles, preferred stock, etc.), 5% Global Bonds.
• Absolute Return Allocator (ARA):  Sold remaining high yield bond exposure; Remains market neutral.
• Enhanced Portfolio Allocator (EPA):  Sold remaining high yield bond exposure; remains 33% exposed to stokcs.
• Enhanced Growth Allocator (EGA): Volatility system bought yesterday, increasing equity exposure from 46% to 66%

How did SEM's portfolios perform?

All losses are painful and I take them very personally.  While I would prefer to never lose money, I know that is impossible.  In order to survive the ups and downs of the market we have to focus on managing the risk in the portfolios.  Once again yesterday was testament to the value of our active risk management:

• S&P 500:  -4.78%
• Income Allocator:  -0.39% (8% of market loss)
• Absolute Return:  +0.02% (has made money every day this week!) 
• Enhanced Portfolio:  -1.72% (36% of market loss)
• Enhanced Growth:  -2.46% (51% of market loss)

As expected, our ENCORE portfolios performed much better, which is why we always recommend using one of our combined solutions inside every clients' portfolio:

• Income ENCORE:  -0.27% (6% of market loss)
• Conservative ENCORE:  -0.53% (11% of market loss)
• Moderate ENCORE:  -0.89% (19% of market loss)
• Growth ENCORE:  -1.72% (36% of market loss)

Growth ENCORE dipped into negative territory for the year yesterday (barely), but all the other ENCOREs remain positive in 2011, with Income ENCORE leading the way at over 2%.  Considering the S&P 500 is now down over 4% year-to-date, we'll take whatever we can at this point.

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