Option Investor
Market Wrap

The Dynamic Has Changed

Printer friendly version

        01-03-2001        High      Low     Volume Advance/Decline
DJIA    10945.80 +299.70 11019.00 10581.10 1.87 bln   2294/ 782
NASDAQ   2616.69 +324.83  2618.03  2251.71 3.18 bln   3062/ 986
S&P 100   703.97 + 36.84   704.58   664.56   totals   5356/1768
S&P 500  1347.56 + 64.29  1347.76  1274.62           75.2%/24.8%
RUS 2000  484.39 + 21.90   484.39   459.28
DJ TRANS 3015.07 +140.96  3016.53  2853.39 
VIX        28.67 -  5.53    34.04    28.47
Put/Call Ratio      0.48

The Dynamic Has Changed

Around 1:15 EST, during a rare inter-meeting gathering, the FOMC cut the Fed funds rate by a full 50 basis points - from 6.50 percent to 6 percent. The results from the FOMC's actions were of historic proportions. The Nasdaq Composite (COMPX) enjoyed its largest percentage gain EVER on the most active trading EVER. When the bullish buying had finished, the COMPX gained over 14 percent on over 3 billions shares traded. The action in the Dow Jones Industrial Average (INDU) was equally impressive. The blue chip index gained roughly 300 points and at its peak advanced measurably above 11,000 to levels not seen since late September. The price action and trading volume in the major indices gave much credence to the Fed's actions and may portend an end to the bear that ravished so many investors during 2000.

The action by Greenspan and his cohorts this afternoon marks a brief moment in financial history. Greenspan is well known to be a gradualist - he moves interest rates slowly but surely. The cut by 50 basis points in Fed funds, along with the 25 basis point cut in the discount rate is a rare event, indeed. As many market watchers know, Greenspan has historically moved rates in 25 basis point increments. In fact, Greenspan has lowered rates by a full 50 basis points on only one other occasion, which was in 1991. The Fed backed its move this afternoon with the following statement: "These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of the financial markets, and high energy prices sapping household and business purchasing power."

Going forward, the market will be listening and watching for further indications of rate cuts to follow the one we received today. There's a 90 percent chance, according to the Fed funds futures, that the FOMC will cut by another 25 basis points at its January meeting at the end of the month. On top of that rate cut, the same futures are predicting another 50 basis points by June. If the futures are a sign of things to come, the Fed will be cutting rates aggressively in 2001. And that means good news for equities.

Now that we know Greenspan and his gang are back on our team, what do we do now? As I have written before, the immediate beneficiaries of a rate cut are the most sensitive to the cost of capital and the business cycle. The sectors to look in are the old economy blue chip names in such spaces as papers, financials, retailers, capital goods makers and industrials, among many others. The financials are worth examining closely at this juncture. Some specific names to watch over the next 48 hours (and nine months) include: J.P. Morgan (JPM), Charles Schwab (SCH), Bank One (ONE), Merrill Lynch (MER), Citigroup (C), Goldman Sachs (GS) and General Electric (GE) - a very interest rate sensitive company. Of course, the preceding names are simply a starting place to look for opportunities in light of the friendlier interest rate environment we were given today. But lower interest rates will immediately benefit those very types of companies and should send their respective share prices higher.

And if you're looking for more interest rate sensitive names, look no further than the good old Dow Jones Industrial Average (INDU). If you don't believe that the INDU likes lower rates, take a look at the chart below. The INDU gained over 350 points in the space of the fifteen minutes following the Fed's announcement. Now that's what I call confirming price action!

And although the INDU enjoyed a monstrous gain today, it was still unable to close above the psychologically significant 11,000 level. However, the INDU was able to pierce that level during its peak, as I previously wrote. Going forward, the 11,000 resistance level will be the key hurdle for the INDU to clear. A strong move above that level may allow for traders to gain entry into some of the blue chip names that comprise the INDU, such as the aforementioned General Electric. If the bulls have truly gained control of the battle, we could see the INDU clear the 11,000 level early tomorrow. Watch it closely!

While the pictures in the INDU and the more interest rate sensitive sectors are becoming very clear, the picture in the Nasdaq Composite is a little more clouded. And the reason for that is the debate whether or not today's interest rate cut will immediately benefit the tech sector. Some market watchers argue today's move by the Fed, in effect, formed a bottom for the tech sector. And while the Nasdaq may have found bottom, others argue that the tech sector needs time to repair and consolidate its heavy losses from 2000. Furthermore, the bears argue that today's rate cut won't prevent any shortfalls of tech bellwethers during the first half of 2001. Many market watchers are still speculating that several big cap tech stocks have yet to warn, and they feel those warnings are looming in the shadows of today's rate cut. Case in point was this evening's warning from fallen Internet star, Inktomi. The Internet software developer said its first quarter earnings and sales would fall short of expectations. And while Inktomi is no Cisco Systems or Sun Microsystems, its warning does serve as an example of the risks that remain in the tech sector. Shares of Inktomi gave up all of their post-Fed announcement gains following the warning. The stock settled at $18 11/16 during the regular session and was last trading around $14 in the after hours session follow the warning.

But if your specialty is the Nasdaq, and you must trade tech from the long side, let me offer the following. While I feel a trader can aggressively pursue the financial and other interest rate sensitive names following the Fed cut today, I do believe the names in the tech sector will require much more discretion and careful selection. Along with increased selectivity in the tech sector, I feel that it's imperative to trade with extreme discipline while the Nasdaq tries to digest today's actions from the Fed. I think there will be increased volatility as the bulls and bears duke it out in the tech sector and that battle will require traders to use tight stops - clearly defining any risk to the downside. I want to write that the Nasdaq is going to keep trading higher and that readers can buy calls on any four-letter stock, but I just don't think that's the case, not yet anyway. The Nasdaq was a complete disaster last year and that type of damage requires a lot of time to repair. And while the Fed's actions clearly shifted the psychology in the tech sector today, whether the bulls are free to run remains to be seen. Don't get me wrong. I'm not bearish on the Nasdaq by any means. I just want to make it clear that risks still exist in the tech sector and if you do wade into that group of stocks, be careful!

While today's rally erased much of the damage done over the past two weeks, let us not forget about the overwhelmingly negative trend the Nasdaq has been battling since September. And let me reiterate that I'm not bearish on the Nasdaq, but the path of least resistance is not yet clearly to the upside. Only the Nasdaq will tell us when it's ready to roll higher and we must pay heed to its clues. And at the risk of boring our readers, I must reiterate again that if you're trading four-letter names from the long side use tight stops that will clearly define downside risk.

Now that I've begged for caution among the Nasdaq traders, let's cover how today's interest rate cut adds a little ammunition to the tech bulls' case. The lowered interest rates today, and additional cuts expected, will allow for higher price-to-earnings multiples among the tech high-flyers. The reasons for that is the obvious up-tick in the business cycle along with the lower cost of capital. The bulls might also argue that there still exist a large number of shorts in the Nasdaq, along with the S&P 500. I know a few professional shorts, and I know they don't like lower interest rates. The historically high levels of shorts in the S&P 500, along with the bears in the Nasdaq, will be bringing in some of their shorts over the next few days and I bet the bulls will try to squeeze them out of their positions. It will take some time to cover all of the short interest that is currently residing in the equities, options and futures markets. That said, an extension of the Nasdaq's rally over the next two days might not be out of the question if those big shorts start bringing stock in.

And those shorts may have enjoyed 2000, but their fun may soon come to an end. Today's move by the Fed may very well bring an end to the bear that tortured the better part of U.S. equity markets for the last nine months. The Fed IS more powerful than any bear. The threat of a nasty recession has been looming in the shadows for some time now, and the Fed just erased the lion's share of those fears today. While we may still witness a mild contraction in GDP, the worst fears are gone. Isn't it amazing how much can change in one day?

Although the Fed is now on our team, it doesn't mean we can go out with reckless abandon and buy everything in sight. Our usual rules of discipline and risk management remain in the toolbox, but the tape might become a lot easier to read as the market foreshadows a pickup in the U.S. economy. It's been a historic day on many fronts and it's only going to get better for those who stay the course and trade with discipline. Good luck in 2001 and stay tuned to OptionInvestor to help guide you through the game we call the stock market!

Eric Utley
Assistant Editor

Market Wrap Archives