Option Investor
Market Wrap

Be careful what you wish for, you might get it!

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         WE 9-24          WE 9-17          WE 9-10           WE 9-3
DOW     10279.33 -524.30 10803.63 -224.80 11028.43 - 50.02  - 11.72
Nasdaq   2740.41 -129.23  2869.64 - 17.32  2886.96 + 43.85  + 84.21
S&P-100   672.80 - 32.16   704.96 -  7.83   712.79 -  1.10  +  5.92
S&P-500  1277.36 - 58.06  1335.42 - 16.23  1351.65 -  5.59  +  8.97
RUT       417.09 - 17.37   434.46 -  6.73   441.19 +  5.22  +  3.52
TRAN     2878.72 -121.07  2999.79 - 91.04  3090.83 - 66.07  - 14.45
VIX        29.54 +  5.32    24.22 +  1.87    22.35 -   .96  -  1.82
Put/Call     .74              .67              .52              .57

Be careful what you wish for, you might get it!

On Thursday I said the ideal situation would be another big drop on Friday to clear out the remaining sellers and make buyers feel safe to open new positions. It would have been hard to script the trading day Friday any better. Of course it depends on what side of the table you were on when the market opened but I was happy as new puppy in a house full of kids.

We got a little bump right after the open that let traders with open positions to sell into strength. And there must have been a bunch of them because the next two hours were all down hill. After breaking all the way down to 10190 at 11:30, the bullish sentiment gave the few brave buyers still in denial of the sell off a buying opportunity. Those with experience held back with the feeling that there was more to come. There had to be more to come. With G7 this weekend and Greenspan on Monday, there were still holders that wanted out. Right after lunch the real carnage began again. Check out the chart above and observe how much steeper the drop at 1:40 and the recovery at 3:PM were than the morning sell off. Morning holders still had hope, afternoon sellers just wanted out. The afternoon low of 10187 was a strong retest of the morning low and gave us a firm rebound. The second dip was buyable and in retrospect the first dip was also but I think the word "lucky" would apply to them.

Are we there yet? Was that a double bottom at 10190 twice today or was it just a coincidence? Does it matter? Analysts are split over reading the technicals at this point. Technically we are in deep trouble. The Dow broke it's 200 day moving average, 10252, but rallied at the close to end back above it at 10279. Too close for comfort. Traders are holding their breath and consoling themselves with the last hope that it didn't "close" under the 200 DMA and therefore they are still clinging to hope that the market will recover. Most traders are still in denial of the facts while technicians just keep checking off the facts. The S&P broke it's 200 DMA at 1301, AND DID NOT RECOVER, closing today at 1277. The S&P danced with the bear today as it dropped below the August low of 1267 but was rescued by the tech rally just before the close. A close below the previous 1267 low would have produced strong sell technical sell signals.

The Russell-2000 broke it's 200 DMA of 425 on Thursday AND DID NOT RECOVER, closing today at 417. The Dow Utility Index broke it's 200 DMA on 9/20 at 311 and DID NOT RECOVER closing today at 295. The transports broke their 200 DMA of 3264 back on August 6th and DID NOT RECOVER closing today at 2879. The transports are down over -30% since their high of 3800 in May. Remember the transports are supposed to confirm Dow direction not diverge from it.

Bored yet? The advance/decline line, negative again today by a 2:3 margin, is at the lowest level in three years. But you say it has been negative for a long time and the Dow set new highs. True. Historically the advance/decline line peaks 12-18 months before the start of a bear market.

Take a look at the chart and you will see the A/D line peaked in April of 1998. Using the outside range of 18 months then October would be the start of a bear market. In reality we could be late to the party already and our start could have been last week. ACTUALLY, if the truth be known, we are already in a bear market. Confused? This is a phenomenon we have reported on before. The recent market highs have been solely on the backs of the large cap stocks. Investors have been reluctant to put money into small cap stocks with Y2K in the headlights. Money in blue chips can be moved to the sidelines much quicker and easier because of the volume and liquidity. Now the real killer. Only 31% of the stocks on the NYSE are above their 200 DMA. Most are down between 25-40% from their 52 week highs. If a bear market is defined as a -20% drop in price then 69% of the market is already in a bear market. The stealth correction as it has been called is being disguised by the money moving into the large caps and holding up the major indexes, S&P, NASDAQ and DOW.

Now I know you are confused. Did I get struck by a lightning bolt somewhere between "I am expecting a rebound" and "look out for October." I hope not. I have been calling for a down market by the second week in October for nine months now and anyone reading the letter faithfully will know this. Am I talking out of both sides of my mouth? No, just different time lines. I AM expecting a rally next week. Actually I am praying for a rally next week. After Friday I have a couple hundred contracts of ITM call options and I am expecting a sizeable profit for my efforts. It is very seldom that the market gives us this type of opportunity.

Cut to the chase. The Dow is down -524 points for the week. Depending on your outlook the Dow was down at the low Friday -8.5% from the intraday high of 11142 just ten days ago. A huge short term drop that is bound to have at least a small technical bounce. In technical analyst terms the Dow was down -10.5% from the recent high of 11365 on August 24th. Is there a difference? Yes in some circles. The latter number would qualify as a short term correction and signal an OK to go back into the market. Personally it is just words and the market could care less which view you have. The only action/reaction we should care about is a rebound from a -955 point intraday drop in the last ten days. Nothing moves in a straight line and the drop from 11142 has been pretty straight. This chart needs a serious bump to equalize the pressure.

The Nasdaq shows a better picture of the double bottom and also shows the danger of a big cap led rally. The Nasdaq Index was holding just under it's recent high of 2880+ until the big cap leaders were hit by the Ballmer bomb on Thursday. The Internets were still up and some with big gains for the week but the Nasdaq dropped -160 intraday on Thr/Fri solely on the big cap slaughter. Indexes do lie.

Where do we go from here? I think the Nasdaq will rebound first since tech stocks are the strongest sectors. The Ballmer bomb was just an excuse for profit taking. The real worry here is the Taiwan earthquake impact on the chip/PC sector. If the damage was greater than expected then chips and mother boards will be delayed and there will be a component shortage for the big fall selling season. This will impact earnings outlooks and therefore stock prices. Dell, CPQ, GTW, HWP, AAPL have already tanked on the possibility. The chip sector has already tanked as well but stands a good chance to rally on better than expected damage reports. Even if the Nasdaq rallies back from the drop, the Nasdaq will eventually follow the Dow. What is really important is the Dow. It is amazing how much of our future is tied to the fortunes of just 30 stocks.

Where is the Dow going next week? To analyze the Dow you have to analyze the stocks in the Dow. This is one of the reasons we have the "Dow 30" chart link on the website. It is critical to investors to have some idea of Dow direction before putting their hard earned capital at risk.

Here is my analysis of the prospects of the Dow stocks next week. This is a quick and dirty snapshot and of course could bear no relation to reality. For the Dow to go up it simply requires the rising stocks to go up more than the declining stocks go down. (I know this seems overly simplistic but bear with me)

Dow stocks expected to be basically flat = no material influence.

AA - Alcoa
CAT - Caterpillar
IP - International Paper
MCD - McDonalds
WMT - Walmart

Dow stocks expected to go down.

UK - Union carbide (earnings warning)
S - Sears (dropping sales)
ALD - Allied Signal (Takeover by Honeywell, HON dropping)
T - AT&T (increased competition by MCI/Sprint, BEL/VOD, etc)
CHV - Chevron (oil sector tanking)
KO - Coca Cola (earnings warning)
DD - Dupont (rising oil impacting earnings -16 since August)
XON - Exxon (oil sector tanking)
GM - General Motors ($5 billion judgement in CA. -32 since May)
GT - Goodyear (earnings warning)
JNJ - Johnson & Johnson (at support but -15 since August)
MRK - Merck (flat to down since May -20) MMM - 3M (earnings worries -10 in ten days, could bounce)
MO - Phillip Morris (new legal problems - no hope)
BA - Boeing (aerospace slowdown)
DIS - Disney (trending down since 8/24)

Dow stocks expected to go up.

AXP - American Express (financials starting to recover)
C - Citcorp (financials recovering)
EK - Eastman Kodak (flat to up, worst is over, upgraded)
GE - General Electric (good upward pattern, close to new high)
HWP - Hewlett-Packard (technical rebound from oversold condition)
IBM - IBM (bounced off support at $120, technical rebound)
JPM - JP Morgan (earnings warning candidate but improving)

Possible bounces

PG - Proctor Gamble (trending down but possible ST bounce)
UTX - United Technology (trending down but possible bounce off $56)

So out of 30 Dow stocks only nine are expected to go up and two of those are questionable. Can the seven stronger possibles go up more than the 23 flat to down stocks will drop? If each of the seven went up +5 and the sixteen weak stocks only dropped -3 in the next two days then we would be net -13 dollars. Now each Dow stock is not created equal and a $1 move in each stock will equate to a different move in the average. AXP for instance carries the largest weighting with a 6.72 and Sears is the lightest at 1.481. Our best hope for next week lies in the weighting of the seven stocks most likely to go up. The combined weight of the seven is 34.99. This means that they control 35% of the change in the Dow. Here are some links that explain the Dow in more detail.

Facts about the DJIA
Company weighting

Here are some links to the Dow 30 charts on our website.

Dow 30 daily
Dow 30 hourly

What does all this mean? It means that with any luck on Monday we could see a decent jump in the best seven and some follow on by the other 23. The G7 meeting, however, may have put a crimp in a Monday rally possibility. Long term, by the end of the week, it is a very good possibility that the 23 dogs will drag us down again and set the stage for another market event. I think any rebound rally next week would be a good opportunity to sell any outstanding open positions and get ready for a possible October decline. I will remind you that the bottom of the market this time last year was October 8th. The defining factor this year will be the lingering Y2K cloud and that could prevent any major upside any time soon.

The G7 meeting was this weekend and it appears that it was left up to Japan to put a lid on the rising Yen. While everyone expressed concern, the problem was left to Japan to correct. In a nutshell, this is not what the markets want to hear. The markets wanted something more concrete and leaving any economic moves up to Japan is like waiting for tax cuts in the U.S. Everybody talks about it but nobody ever does anything. This could be a market mover on Monday DEPENDING on the final news reports from the meeting and the SPIN applied to those reports.

As if we did not have enough to worry about there are some important events on the calendar. Greenspan is scheduled to talk on Monday, and there is a whole list of economic reports out later in the week. The next major milestone is the FOMC meeting on interest rates on the following Tuesday. The closer we get to the end of the week the more traders are likely to pull back and adopt a wait and see attitude before opening any new positions. There is about an 85% chance the Fed will raise rates again but the market drop, some recent weak reports and impending Y2K could cause them to reconsider. Some feel a rate hike is already priced in and a failure to raise would ease any October crash worries. Fortunately or ?? the September Jobs numbers will not be out until Oct 8th, after the FOMC meeting. They will have to go on the info at hand and we will not be tortured by waiting for a bad jobs report and having them raise rates in a knee jerk reaction the next week.

The bottom line: If you have open call positions, close them in any rally. You can always open new ones after the Fed meeting if the market rallies. If you have the capability to write calls then any failed rally on Monday/Tuesday would be an excellent opportunity to write October calls. Since Oct 1st is a Friday, we are only three weeks from the October expirations.

BOLD IN ENGLISH: EVEN THOUGH THERE ARE CALLS LISTED IN THIS NEWSLETTER I STRONGLY ADVISE AGAINST OPENING ANY NEW CALL POSITIONS UNTIL AFTER THE FED MEETING AND MARKET DIRECTION IS ESTABLISHED. Use the recommended call plays as suggestions to play AFTER the Fed meeting. Put them on your watch list and see which ones act the best over the next week. Those are the ones to play after the Fed meeting.

WAIT FOR AN ENTRY POINT and sell too soon.

Jim Brown
Editor

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