Option Investor
Market Wrap

Get out the Raid, the cockroaches are running.

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        WE 6-16          WE 6-9           WE 6-2          WE 5-26
DOW    10449.30 -164.76 10614.06 -180.70 10794.76 +495.52  -327.61
Nasdaq  3860.56 - 14.28  3874.84 + 61.46  3813.38 +608.27  -185.29
S&P-100  788.74 +  9.04   779.70 - 12.99   792.69 + 56.61  - 16.87
S&P-500 1464.46 +  7.51  1456.95 - 20.31  1477.26 + 99.24  - 28.93
RUT      513.74 -  9.32   523.06 + 10.03   513.03 + 55.66  - 22.33
TRAN    2673.19 -116.98  2790.17 - 39.19  2829.36 +141.81  - 54.45
VIX       23.55 -  1.64    25.19 +  1.08    24.11 -  3.38  -  1.28
Put/Call    .53              .45              .41              .65

Get out the Raid, the cockroaches are running.

The market was staggered this week as a flurry of cockroach sightings sent institutional traders to the sidelines. The earnings warnings sent shivers up the spine of even the most aggressive traders. The problem is not so much the ones that warned as the ones that have not warned yet. Using whatever analogy you want, cockroaches, mice or moths, there is never just one. If you see one you can bet there are many others still in hiding. Roger Perry calls this the "cockroach theory." When referring to earnings warnings the analogy is very true. When one company in a sector warns it is likely only the first one to appear. Using the warnings in the financial sector recently you can see how this works. One broker warns that slowing volume would impact earnings and others follow suit on the heels of analysts downgrades of the sector. A major bank warns this week and smaller banks follow suit. Sector downgrades after the announcements push prices down even further.

Last week I said any Dow rally would have to be led by the financials which were already bloody. After the Wachovia warning this week the financials are still leading the Dow, down not up. Sector leaders were racing toward the cellar on Friday on fears of the continued impact of higher interest rates. JP Morgan had a huge drop of -$9 along with the most recent earnings warning UnionBanCal also -$9. Adding to the overall stink was TER which said bookings would be flat for the second quarter compared with previous estimates of +10%. Xerox joined the parade with a warning that earnings would be below estimates due to soft sales.

As more and more companies confessed their sins, investors became more unsure of which way to jump. The only sectors that were showing strength were Oil Service, on $31 oil, and some defensive stocks like drugs. There simply appeared to be no safe haven. Tech stocks, which are very susceptible to warnings, managed to hold their own but the Dow drag prevented any rally. The Dow, which had been flat on good economic news Wed/Thr, dove at the open then firmed at lunch as bargain hunters came off the sidelines. The bears slammed the door behind them as the waves of selling began again about one hour before the close. The volume was heavy with over one bln shares trading on the NYSE. The end of day volume was very heavy for a summer Friday. There were huge order imbalances at the close with large blocks of "sell on close" and almost no buyers. The Dow was showing -234 at the bell but dropped another -30 points as trades settled out over the next 10 minutes. Closing at the absolute low of the day on exceptionally strong closing volume does not bode well for open on Monday. Some analysts think it could have been due to the triple witching options expiration but it would be contrary to this weeks action over the last year. Volatility due to witching has been taking place earlier in the week for quite some time and heavy Friday trading has been non existent. I think it was fear of future warnings that finally pushed some institutions over the edge.

Economic reports on Friday were very market friendly on the surface. With housing starts coming in at the lowest in a year, down -3.9%, and housing permits dropping -4.3% you would have expected the market to rally as Fed fears decrease. What overcame investor optimism was the worry that the economy was slowing too fast. The ripple down impact of just the housing drops would hurt wood and paper companies as well as appliances, furniture, etc. Some analysts are now predicting only a +12% growth in earnings for the S&P compared with previous estimates of +18%. This is a huge drop of -33% and considering the heaviest warnings do not occur for two more weeks the worst may still be ahead of us. The most warnings occur the last week of June and the first week of July.

I started planning this commentary with a bullish bias, again. However, my outlook changed the farther I got into my research. On the positive side I felt the Nasdaq was still building support just under 3900 and preparing for an explosive breakout. To support my positive market bias I felt the OEX and SPX, which are better indicators of the broader market, were also building support at the higher end of their recent ranges. Also the QQQ failed to break support at $90.

What changed my view was the high volume selling at the close Friday and the realization that the worst is still ahead of us in terms of warnings. Now remember it is the perception of reality that governs our fate, not reality. If institutional investors feel that the next three weeks are going to be very rough and they move to the sidelines then it makes no difference if the warnings actually come to pass. The move to the sidelines in advance will control the market direction next week. Factor in the Fed meeting on the 27/28th and you get another rocky week. It makes no difference that most expect no hike from the Fed. It is the Fed dread that causes the volatility.

A bull could look at the three charts above and visualize a possible breakout since all are trading at or near the high points in their range. A bear would look at the three charts and visualize a possible roll over on each since that is the current trend. A bounce off upper resistance and fall back again.

The key here is still "planning your trades and executing your plan." Our plan from last Sunday was to be market neutral. I suggested that 3900 was the current target benchmark. A breakout over 3900 on strong volume would be a signal to go long and I suggested staying flat under 3900. If you took my advice you saved a lot of time, money and emotional headaches last week. With the Dow looking like an EKG and likely to continue back down to a retest of 10300 we want to be very careful in the market. By setting a benchmark like 3900 it takes all the complicated decisions out of the market. The Dow will drag on the Nasdaq so the one we want to watch is the Nasdaq. By focusing on the 3900 you eliminate the noise of the market. Last week was VERY NOISY. If you attempted to trade it your results may not have been very satisfactory. Sure there were individual winners like SDLI but overall it was very choppy.

The game plan for this week is still the same. Wait for a breakout over 3900 on strong volume and then go long. The economic calendar is very light which could give us some positive bias but institutional investors will be listening with a stethoscope for signs of possible earnings warnings. WHEN they come, the sector for each offender will be hit with downgrades and selling. Your stock may not warn but if another leader in the same sector warns then your stock will drop in sympathy.

Trade smart, don't buy too soon.

Jim Brown
Editor

This week I am reprinting my "Exact Instructions" Options 101 article from last fall. This article was in answer to readers requests on how to turn $10,000 into $50,000 in one year using options. Check it out on the website. http://www.optioninvestor.com/page/oin/education/opt101/1999/12-05.html

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