A World of Change
I don't know about you, but is anyone else just a little tired of hearing about the "old economy" versus the "new economy". Come on media people; we got it already. Unfortunately, those two ideas, old economy versus new economy are affecting the market in very big ways. Now, just to spare everyone from reading yet another commentary inundated with those two terms, I'm going to substitute "old economy" with "old world" and "new economy" with "new world". Sounds nice, doesn't it. We are all adventurers at heart. Otherwise we wouldn't be taking charge of our own financial future as we strive to find the next successful trade.
It probably doesn't sound very nice no matter what you call it if you were trading Dow stocks on Friday. Trading was ugly from the word go and the venerable index struggled for a whole 90 minutes (11:30 to 1:00pm) with support at 10,000. Investors were relieved to hear the closing bell since it called an end to an ugly week on the NYSE. However, by the time the smoke cleared, the Dow Jones Industrial Average had crossed not one, but two lines in the sand. The milestone of Dow 10,000 was bad enough, but the index broke through 9900 in the last half hour of trading before closing at 9878. The damage was a 230 point loss.
This marked the fourth Friday out of the last five Fridays that the Dow has lost over 200 points. Clearly the bulls are not willing to hold over the weekend and the bears are more than happy to take advantage of that fact. If you remember the wrap on Tuesday, we were very suspicious of the bounce on the Dow and suspected it to be the third in a series of bear traps.
chart of bear traps
As traders saw the Dow index close below the psychological level of 10,000, you could almost see the fear in some of their minds. Is this the beginning of the end? No one really knows; but this wouldn't be the first time someone wrote the epitaph for this bull market a little prematurely. At the end of this month, next Tuesday, we will have marked our 107th month for the longest expansion in history. A normal economic expansion is closer to 43 to 50 months long. How can we not expect a few bumps in the road with a journey this long. If we survive next month, the 108th month, this bull market will be nine years old.
Technology has not only extended the life span of humans, but of the business cycle as well. The question is, can technology stop the cardiac arrest that is affecting the "old world" stocks. The markets have put on a pretty frantic run the last 10 to 12 months but the Dow appears out of breath. It was 10 months ago last April that the Dow last closed under 10,000. Since that time the Nasdaq has gained about 80%. In comparison, the Dow is down almost 16% from its Jan. 14th closing high of 11,722 versus the Nasdaq's 13% gain for the new millennium. According to Markethistory.com, the Nasdaq has outperformed the Dow by over 40% in the last few months. This is the widest divergence in the history of the two indices. Many are concerned that a divergence this size only spells trouble and it will likely correct and painfully so. (more on this later)
chart of the Dow versus the Nasdaq
Trading activity on both exchanges was hectic. The NYSE saw over 1 billion shares traded while the Nasdaq exchanged more than 1.8 billion. Breadth was negative and combined advancers lost to decliners: 3103 to 4030. The overall trend between the two could be seen in new 52 week lows to new 52 week highs. The NYSE had 46 new highs and 192 new lows while the Nasdaq glowed with 280 new highs and 92 new lows. The broader markets reflected the Dow's bearish stance with the OEX falling 11.38 to 719.78, the SPX fell 20 to 1333.36, even the Nasdaq gave up a few points to fall 27.15 to 4590.50. The only shining star among the major indices was the Russell 2000. The RUT gained 2.70 to 556.74.
Last week Jim discussed where the Dow 30 stocks were and how they could affect the valuation of the DJIA. Without going into the same detail, I want to point out that several stocks in the Dow still remain weak and a reversal is not yet imminent. Actually, I've reduced this study to an informal poll. How many of the Dow 30 stocks are at or near their 52 week lows? 10. How many of the Dow 30 are turning over? 8. How many have given us a technical breakdown (this week)? 4. How many are just plain crashing? 4. This gives us a total of 26. Now, one more question. How many of the Dow 30 stocks are under their 200 dma? Answer: 22. Needless to say, we are not looking at a very healthy picture as the majority of these "old world" stocks are being left by investors for the "new world" performance stocks. Why would you buy and hold IP for two years and loose 20% when you could buy stocks like CMRC or ARBA (B2B companies) and make 20% in one (CMRC) or two (ARBA) days ? Hmmmmm? I'm waiting for an answer... Exactly, you wouldn't.
chart of IP versus ARBA
"But wait, maybe this is just an over reaction to the GDP and housing starts that came out on Friday", cries the diehard Dow fan. It is a possibility, but looking back now, Friday's results seem inevitable. Economists were looking to revise 1999's 4Q GDP up from 5.8% to 6.5% and when it came out to an unexpected 6.9% investors reacted. This is almost twice what the Fed chairman Greenspan would like to see economy grow at. The last time the economy was near the 7% growth rate was when it hit 7.2% back in the 4Q of 1987. Everyone should know what happened in 1987. You don't? Okay, here's a hint. It happened on a Monday but that is all I'm going to help you with.
The unexpected GDP results renewed interest rate fears. You've probably heard that a dozen times this weekend but ask yourself why? Everyone expects Greenspan to raise rates again at the next FOMC meeting on March 21st and probably again at the June meeting. However, if the economy is too strong, investors worry that he may be tempted to raise by 50 basis points or worse - a possible surprise rate hike before the next scheduled meeting. Fortunately, we still have two factors on our side. Number one, inflation remains in check. The GDP price deflator, one of the inflation gauges the Fed watches, only rose at a 2% annual rate inline with estimates. Number two, the Fed governor's previous string of rate hikes may be having their intended effect. The National Association of Realtors reported a 10.7% decline in home sales for January. This was the largest monthly slow down in over three years. Most economists agree that Alan's last four rate hikes will prevent Q1 of 2000 from outpacing the end of 1999.
Now, how do we apply this to our trading next week? We are probably looking at two scenarios. Scenario one, the weak stocks drag the strong stocks down with them. The Dow has corrected almost 16% from its high and we are firmly in correction territory. Investor sentiment is wary for the Dow and this may be the beginning of a bear cycle for the index. Not surprisingly, many of the non-tech sectors have corrected as much or even more. Many of the cyclical stocks are down over 20% in the last eight weeks (definite bear market here). One thought among the bearish camp is that we can't experience the bottom or reversal we are looking for until the strong stocks pull back and correct as well. This is a possibility as the true impact on investors' sense of confidence with the Dow closing under 10,000 may not be fully known for days. It was a little bit disturbing for some market pundits to note that several of the Nasdaq mega-caps, like MSFT, WCOM, DELL, SUNW, CSCO, were all down for the day.
Technically, the market can correct in a couple of ways. We can experience a short, sharp, high volume washout across all the sectors or we can suffer through a softer but extended round of consolidation. At the moment, neither appear to be more popular than the other, but if I had my choice I'd prefer fast and sharp. It's just like getting punished as a kid. Don't give me the two-hour lecture and then spank me. Just spank me and get it over with.
Scenario two: The dual market continues. While not the only spokesperson for this belief system, Banc of America analyst, John Zimmerman, feels that this divergence between the Dow and the Nasdaq will continue for the next several quarters. Investors doing their homework can see that it is almost a dollar for dollar move between the two "worlds". For every dollar investors take out of "old world" stocks in the Dow and on the NYSE they are buying a dollar of "new world" stocks on the Nasdaq. Somewhere, somehow, someone has infiltrated the mind of the masses and convinced them that high-growth tech stocks are insulated from the dangers of higher interest rates. While this may hold true for the short term, old-school traders have no doubt that even the old rules will catch up to the Nasdaq some day. The challenge is that "some day" never seems to appear. Scenario two is not perfect. If the dual market continues, we are likely to see extremely short sharp corrections within individual sectors as stocks suffer the usual sector rotation.
Furthermore, scenario two will continue to benefit from the enormous amount of liquidity for Nasdaq stocks. Sure, we've already mentioned that traders are taking money out of the "old world" stocks. So are a lot of institutions. For some funds, if a stock drops below its 200 dma, they have to sell. Even worse for the "old world" stocks is that value funds have been left in the dust by their high-growth tech fund brethren. Last week, Jim mentioned how several have ceased to exist or are being phased out and merged. This leaves no one to pick up these "bargains" in the "old world" sectors. If you are long these equities, you don't want to be asking yourself, "how low can they go?" On the other hand, look at the tech fund managers. Each month you have umpteen million dollars coming in and you are not allowed to sit on it very long. You're going to have to put it to work somewhere and the best place is the Nasdaq (or the Russell 2000). Now you're faced with the dilemma to purchase a bunch of tech stocks that you think are overbought and too expensive. To make matters worse, you are competing with hundreds of other fund managers for the same issues. No wonder some of these stocks climb 30 points in a day.
Reality is likely to be some combination of the two scenarios above. Interest rates will remain an issue. Fortunately, some market commentators feel that the last rate hike will be in June. Why? Because the Fed is likely to remain inactive when the political process heats up next fall. The bad news is politics isn't the only thing heating up. Oil prices continue to surge and April crude closed over $30 a barrel on Friday. The 13-month trend in oil prices does not appear to be abating.
We do have a few events to look for next week. 3Com is expected to IPO their much anticipated palm pilot unit late in the week. There has been so much excitement over this IPO it is liable to be a winner. On Wednesday we have the NAPM report. This should come out around 10:00 a.m. ET and could have market moving consequences. Economists will be watching as the report details several sub-indices that are leading economic indicators. Plus on Friday we have the big one. Before the bell, the Employment report will hold everyone's attention. If unemployment falls under 4.0% the markets may overreact. Actually, if unemployment falls to 3.9% it will be the first time since 1970.
Also on the agenda for next week are a few earnings reports. Some of the larger companies reporting are: for Monday, Protein Design Labs (one of the recent biotech rockets); for Wednesday, Tiffany, TJX, and Michael's stores; and for Thursday, Verio, Staples, and Costco.
As long as we have our eyes open for the big events, don't forget to watch the charts. We mentioned earlier that a close under 10,000 could preclude a move to 9300 or 9000. However, the Dow's next support level looks like 9650. Dow 9650 was an early top in Jan. 1999 and a subsequent bottom in March of 1999.
chart on the Dow.
What is a little unnerving is the Dow's close under its 20 month moving average. This does not paint a strong technical picture.
chart on the Dow
The OEX is looking ugly as well. Currently it sits just above its 200 dma at 716. A breakdown from here could herald a run to 700.
chart on the OEX
The S&P 500 (SPX) is worse. We've already broken through the 200 dma and have tried three times to close above it - all to no avail. Friday's close was ominous and 1300 could be a psychological support level.
chart on the SPX
On the other hand, the Russell 2000 looks very strong. Think of its as the broad market for the Nasdaq. The small cap index is up over 10% for the year. 560 is resistance.
chart of the RUT.X
In my final comments, I would consider doing a little soul searching if I owned any of the Dow or "old world" stocks. Besides being extremely oversold, nothing precludes this correction from turning truly bearish. One question I would ask myself was, "why didn't have I have a stop loss?" Then I wouldn't be asking myself if this was the time to sell and I'd be sitting in cash looking for the next trade.
The Dow struggled with 10,000 and lost. Where the Dow goes from here is anyone's guess. However, and more importantly, how much importance should I assign an index that tracks 30 stocks? Just as many long time traders are questioning their use of the 30 year bond as the benchmark (and considering switching to the 10 year bond), many investors are turning towards the Nasdaq as their new beacon to lighting their way in this "new world".
To repeat the warning from last week, if the Dow breaks 10,000 we should just move to the sidelines to watch. It never hurts to be in cash because it gives you choices and freedom to watch the market without the heartache. It is better to not trade at all than force yourself to trade in a bad market.
It is possible we'll see a relief rally in the Dow but if it closes above 10,000 I'll be surprised. I'm more inclined to watch the Nasdaq for any reaction to the Dow's breakdown than watch the Dow. The Nasdaq is where the action is and my bullish nature is voting for scenario two.
Sell too soon.