Catching the falling knife

With the S&P's downgrade of US debt a reality, the question now is finding and trading the bottom on the market.

The S&P 500, as well as nearly every other stock index, was devastated last week. Fortunes were made and lost, and the careers of many amateur traders likely came to an abrupt end. It still remains to be seen, however, exactly how much more downside is left.

It's very likely that a large part of the selling we saw last week was insider trading based on advanced knowledge that the downgrade would occur. This could mean that the majority of downside is already priced into the market. It's also possible that this is just the beginning and we have a long way to fall yet.

Personally, I believe the most severe selling has already happened. I think it's likely that Monday sees an additional reflex selling flush that possibly even lasts into Tuesday. From there, I think it's possible a short term bottom on the market is in.

Alternatively, fear and panic, as well as hedge funds liquidating their holdings, could drive the markets substantially lower. I think this is the least likely scenario as it assumes that large financial institutions have not yet begun to sell.

In any case, I will be trading carefully. I mentioned several times last week that I would not be holding any large positions into this kind of uncertainty and that continues to be the case. I will be looking mostly at short term scalp trades and closely watching for signs of a low in the market. Once the market bottoms, we should see a substantial relief rally.

Choosing is not a choice

Friday night Standard & Poor's downgraded America's debt rating from AAA to AA+. The "bipartisan" budget deal worked out by US lawmakers last week apparently doesn't pass muster.

This should come as no surprise. The deal is the concoction of a government in gridlock and political parties without the will to make tough choices and risk alienating their most vocal and influential backers. Faced with the option of raising taxes or cutting spending--two very sacred cows--lawmakers chose none of the above.

The situation in the US is unsustainable because neither side of the debate is willing to concede anything, but now something has to give. Spending must be matched with revenue. When the two are out of sequence, the former must be cut or the latter raised--or better yet, both. A business can't survive without this careful balance and neither can a country.

In abandoning this basic principle, the US is now downgraded--and rightly so. Plans that appease everyone serve no one, and so it is with recent American fiscal policy. US lawmakers must prepare to make unpopular decisions or risk worsening an already grave budgetary tailspin.

Americans can either pay more for the services they receive or cut those services and pay less. Both options are valid, but a choice must be made as no combination of the two will work.

To be sure, the coming days and weeks will be crucial ones. Lawmakers and economists will be working hard to assess the damage that has been done and determine a way forward. Traders like myself will be looking to understand this changing dynamic of the global markets and identify opportunities therein.

As this situation unfolds, follow my latest thoughts both here and on Twitter @thetsxpert.

--Read the S&P's downgrade report here--

Debt fears drive markets sharply lower

Today the S&P 500 gapped lower and continued to sell for the majority of the trading session. Traders and investors are clearly nervous that members of the US House and Senate will not be able to reach an agreement in the short term.

As I posted yesterday, I expected increased volatility as we near the August 2 deadline--and volatility usually means selling. However, even I was surprised by the ferociousness of today's sell-off.

Technically, the daily $SPX chart suffered a lot of damage. Both the 61.8 fib and the 50 moving average support levels were broken and prices closed near the lows of the day. However, it's difficult to put much meaning into this sell-off as it was driven purely by fear and not technical factors.

Fear drives the SPX daily below several key support levels

Whatever the reasons, I'll continue to use the charts as my guide. The markets are now very oversold and due for at least a short term bounce, but when that will happen is anyone's guess. My suspicion, as I've written about previously, is that once a debt agreement is made in the US the markets will rally.

Irregardless of an agreement, the SPY filled a key intraday gap today and that alone may be indicative of a bounce in the coming days. I personally took a small long position close to this level as I believe the markets are due for some short term relief. If we continue to fall tomorrow, I will re-evaluate this position based on several factors such as decline velocity and volume.

Gap filled after near continuous selling on SPY 10 min

Please note that even though today's sell-off surprised me, I did not expose myself heavily to the long side--instead opting to slowly accumulate on the way down. The advantages to this approach are minimal losses and the opportunity to buy stocks at lower levels. It is especially important to remain prudent when there are so many political and economic unknowns looming in the near future.

Going forward into the last half of this week, remain cautious and do not weigh yourself too heavily on the short side. The market is incredibly fearful right now and that usually signals that a turning point is near.

For my latest thoughts throughout the day, be sure check here regularly and follow me on twitter.