Option Investor
Market Wrap

Nasdaq +134 in record week, Dow -438 and falling. What is wrong with this picture?

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         WE 3-10           WE 3-3          WE 2-25         WE 2-18    
DOW      9928.82 -438.38 10367.20 +505.08  9862.12 -357.40 -205.29
Nasdaq   5048.62 +133.83  4914.79 +324.29  4590.50 +178.76 + 16.29
S&P-100   749.50 - 16.45   765.95 + 46.17   719.78 -  8.74 - 23.52
S&P-500  1395.07 - 14.10  1409.17 + 75.81  1333.36 - 12.73 - 41.03
RUT       603.81 +  5.93   597.88 + 41.14   556.74 + 11.06 +  8.58
TRAN     2365.29 - 69.16  2434.45 + 83.19  2351.26 - 79.54 -  5.33
VIX        23.80 +  2.51    21.29 -  7.79    29.08 +  0.63 +  1.53
Put/Call     .39              .40              .41             .63

Nasdaq +134 in record week, Dow -438 and falling. What is wrong with this picture?

Extreme divergence. Or is it really just rapid convergence? Whatever you call it the fact is the Dow and Nasdaq are headed in opposite directions at a high rate of speed. Eventually this is going to cause serious problems and from the news reports today it may be sooner than we think. As long as the Dow remained positive Friday, even by only single digits, the Nasdaq was in record setting rally mode. As soon as the Dow rolled over around 3:PM and dropped from +30 to -90 the Nasdaq dropped from an intraday high of 5132 at +83 points to only barely close positive at +1.76. The results of the Dow's drag on the Nasdaq will only get worse as we move farther below 10,000.

The Dow's failure to rally this week after the big drop on Tuesday and the failure to hold over 10000 today has only confirmed the current downward trend line and could be bad news for the week ahead. In addition to the technical problems there are some serious sentiment problems developing as well. Technically the Dow bounced off the exact upper boundary of the down trending channel and technically we could see a drop next week to as low as 9500. The failure to even mount a credible bear trap rally after the big drop has put a serious cloud over the forecast. The volatility is increasing and we have four serious news events next week and none are expected to be market friendly.

The Nasdaq turned in the equivalent of a full reversal with the sprint to a new intraday high of 5132 and then the retreat that gave it all back. This reversal pattern after setting a new high is normally a sign that a rest is in the cards. Who can blame it? With an over 800 point gain (5132-4291=841 points) in only 14 trading days since the Feb-22nd low there is a lot of profit waiting to be taken. We have had three days of -100 or more points to only gain it all back and then some the following day. We should patent this mini correction cycle of approximately once every four days and give it some catchy name like "settlement day" to set it apart from the real -10% corrections. We have had two of the major corrections in the last three months and the Nasdaq is still up over +24% for the year. We are on track for another +100% year and should lock in +30% by the end of March. A 100% year would put the Nasdaq at 8500 by year end. I am certainly not forecasting that but I would gladly take it. Back to the point, the Dow pulled the Nasdaq down today and is likely to do it again next week.

The main catalyst for the drop today was another earnings warning from a major consumer firm. Dial (DL) warned that they would miss earnings by -10% to -12% this quarter and the resulting -$3 drop in price put them at a six year low. Not that Dial is a real bellwether company but after PG earlier in the week traders are now becoming increasingly worried about who else will come out of the closet in the next three weeks. We are sure to get some more brand names and each will have its own reason for missing the boat but the results will be the same. Market depression due to reduced earnings expectations for those not brave enough to warn.

Another factor that is starting to become apparent is the awakening of the passive investor. Contrary to what you hear about the online investing generation the majority of the investing public are passive investors. Retirement accounts make up the vast majority of their investments. Of these accounts the vast majority are invested in index funds. A simple way to maximize returns safely in a bull market. These funds are setup to mirror the gains in the DOW, S&P, RUT, etc. Works great in a bull market but the same mechanics that reward in up markets also deduct in down markets. The passive investor will remain that way as long as they can pick up a newspaper once a month or so and marvel at how smart they were to invest in XYZ fund which is up another xx% in the last month. Fat, dumb and happy. What some analysts are beginning to see is the awakening of the collective subconscious's of these investors. How many times do you have to see a headline about the Dow being down XXX points before it starts to sink in that maybe there is a problem in the markets? How many times do they have to look in the paper and see a minus sign next to their super fund before they start to wonder about the wisdom of staying invested? What is all this talk about the techs being grossly overvalued, old economy stocks rusting away, Warren Buffett down -48%? Warren Buffet? If the greatest investor of all time is losing money then maybe there is something I don't know. Maybe I should put that money into a money market account instead.

OOPS! A phenomenon almost unknown in a decade called "net redemption's" is starting to appear. Value funds have been Suffering this problem for months and now index funds are beginning to see a net outflow of cash almost daily. Since index funds are not banks and are paid to hold stocks not cash, they have to sell stock to get the money for redemption's. When they need to sell large amounts of stock they use a type of order called "order on close". Instead of impacting the price negatively during the day by dumping large blocks of stock they place a "sell on close" order and they get paid whatever the closing price is for their stock. The market makers have an advantage in knowing when and how much stock is going to be sold and they can stockpile buy orders to offset the large block they are going to have to handle. At about 3:30 these "order on close" orders are made known on the floor of the NYSE. Recently the number of "sell on close" orders has been rising. On Friday there were blocks of several hundred thousand shares going out at the close. One block was 446,000. The public is starting to move and once in motion it will be hard to reverse the trend. This could cause the cycle to accelerate as the liquidity which has been powering the market begins to dry up.

Before you start crying foul I will tell you that more money came into the market in the last two weeks than most full months of last year. The problem is that it did not go into value funds or index funds. It went into growth funds and tech stocks. This is money that came out of the Dow and out of the S&P. It is accelerating the Nasdaq and decelerating the Dow. I wrote a couple months ago that I expected the Nasdaq to possibly pass the Dow late this year. It is looking more and more possible and probable as the calendar unwinds. If the Dow did nothing and the Nasdaq continued to add +25% a quarter as it has in the last twelve months then they would meet at year end. Instead the Dow is on a downward spiral that is dropping twice as fast as the Nasdaq is advancing and they could converge as soon as September-October. That is of course depending on how much the Dow drop continues to degrade the market as a whole. While the outlook for the Nasdaq is stellar there is always the chance that investor psychology could turn based on the "perception" of a negative market due to the media coverage of "Dow" as the "market". It is this "bear" market mentality that we will need to avoid as we progress farther into 2000 and continue to benefit from the Internet revolution. It is not a bear market. It is sector rotation in its purest form.

The Internet is fueling record increases in productivity, competition, cost savings, connectivity, research, communication and cooperation. News of scientific discoveries like we are seeing in the biotech sector almost every week is available almost instantly across the net. Large strides in computing power and chip technology are increasing daily. Still shampoo is still shampoo and consumers are fickle. They will shop where the variety is greatest at the best price. That may not be a brick and mortar store. Companies that have been around for decades and are mired in the old sales and marketing paradigms will continue to suffer until they reinvent themselves and conform to the new Internet model. Earnings warnings? You bet. Count on many of them. Also count on many "better than expected" results from the "new economy" companies. (I am really growing to hate those terms already) Now I ask you, which type of company do you want to invest in? The answer... 1-800-redeem. Hello Fidelity, you know that index fund I own...... Now you see the problem. "We" are the problem. Welcome to 2000.

Having totally gone off the deep end and rambled for several paragraphs I will try and direct your focus back to what is important next week. Economic reports and lots of them, followed by a Fed meeting. Sounds like a great week to go fishing. Tuesday starts off the calendar with Retail Sales, Wednesday Business Inventories, Import/Export Prices, Industrial Production. Thursday Jobless Claims, PPI, Housing Starts, Building permits. Friday closes with the CPI. Could be a rough week. Follow all those probably negative economic reports with a dose of interest rate fears and a Fed meeting on Tuesday the 21st and you get a real Maalox moment.

The optimistic side of me is saying, "Dow down -438 points" got to be some bargains here somewhere. The pessimistic side is thinking, "I would not buy PG, JNJ, DD, EK, KO, so why should anybody else". Like I said last Sunday there is still a Nasdaq correction lurking in our future and even though it felt bad on Wednesday it was only a blip on the chart so the "big one" is still in our future. It would be nice if we could get through April earnings before we get blindsided by the next trip to the woodshed but April 15th is still a long way off. I would be careful of any Nasdaq weakness next week. With the market (Dow) still in a down trend you never know when the Nasdaq bottom may fall out. The VIX has been easing down from its high of almost 29 on Wednesday. Friday it moved in a narrow range between 23.45 and 25 and finished almost unchanged for the day at 24.17. It is not giving us any signals, buy or sell, at the present. The put/call ratio however is only .39 and indicating some weakness ahead.

Friday night almost all the other editors and writers in the office happened to congregate in one spot where a lively discussion on market direction ensued. Without exception we all believed that the market could and would go down next week. All the negatives both technical and sentiment were being tossed out like so many nails for the Dow coffin. Red Alert! As I pondered the implications for this article Kimo and I slowly came to the realization that everyone had built the perfect wall of worry for the market to climb. Just like I have repeated many times, "when everything looks too good to be true, it probably is" the reverse is also true, "It is always darkest before the dawn". While I believe it could get darker, 9500 would be really dark, there is another axiom that comes to mind, "the herd is always wrong at both ends". If the herd here thinks the market is going down next week does that mean we should take the contrarian view and bet against it? Absolutely not! Never fight the trend. Take all the information you can find from every source possible and then plan for each outcome, up and down. If you pre-plan for both then you will be ready to execute for each direction. Once prepared, sit back and watch the show. Be slow to react at the open and you will save yourself much grief.

I can't tell you how many times I have prepared the night before for my "expected" market direction only to have the market do the exact opposite. Have you ever felt the market was at the bottom and planned to buy OEX calls the next day and all day you just kept waiting for an entry point as the market dropped several hundred points? Had you been market neutral and ready to play calls OR puts then you could have made thousands of dollars. Instead your market bias either kept you out of the market or convinced you a dip was a bottom when it was just a dip. We can't force our view on the market. What we believe is irrelevant. It is up to us to play the hand we are dealt by the market. Most of us would be better off each day if we could call somebody who is not an investor over to the PC, show them a chart of the Dow and ask them which way is the market going. Their answer would be unencumbered by the wealth of "knowledge" that we have been blessed with. Because we know "so much" our vision is clouded. To be successful investors we must get rid of the cataracts of knowledge bias and then clearly follow the road map to wealth the market provides for us on a daily basis.

Buy the dips but only when the rebound starts.

Trade smart, sell too soon.

Jim Brown


Due to scheduling conflicts we have had several cancellations for the March Option Expo Seminar in Denver. The first session for March 25-28th is completely full. There are still two openings for session two, March 28-31st. If you have interest in attending the second session please register ASAP. It is first come, first serve. You will not regret fours days of intense option training by the Option Investor staff.

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My current long positions: CPTH, RRRR, BWEB, KSU, SEG, TXN
My current short positions: RIG, SLB

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