Risk and Reward
For nearly seven months, the shorts and put buyers in this market have been printing money. But those printing presses may be running out of ink as measured by the near-historic advances in the broader market averages Thursday.
The reward in shorting this market, especially the Nasdaq Composite (COMPX), has far outweighed the risk in doing so over the last seven months due to a slowing in the economy and the subsequent impact on corporate earnings. However, that dynamic may soon come to an end as the returns from shorting stocks diminish. But, while the reward in shorting stocks may decline, that doesn't necessarily translate into a new bull market. What it can lend to is a bottoming process in the bear-battered Nasdaq, which now becomes a function of time.
The reward in shorting the tech sector was further diminished after the bell Wednesday, when Dell Computer (NASDAQ:DELL) reaffirmed its first-quarter guidance. As a function of the new SEC Regulation Fair Disclosure (FD), Dell officials told investors late Wednesday, ahead of its analyst meeting Thursday, that it was on track to meet its consensus estimates of 17 cents per share. Dell's reassuring comments are consistent with what Micron Technology (NYSE:MU) told investors two weeks ago. The maker of dynamic random access memory (DRAM) said it was seeing inventories among PC makers clearing and an up-tick in orders. The PC and chip sectors were among the first to fall when the bear market began, and should lead the ultimate rebound. So, the news from Dell Wednesday night (and Micron two weeks ago) obviously lends credence to the formation of a bottom in the tech sector.
In addition to the Dell news, a bullish analyst upgrade boosted the beleaguered Internet sector, which fueled the Nasdaq's rally Thursday. Holly Becker, of Lehman Brothers, upgraded shares of portal giant Yahoo (NASDAQ:YHOO) from a market perform to a buy rating. Let me repeat that: Yahoo was UPGRADED this morning! Upgrades in the Internet sector have been virtually nonexistent, and I feel that Becker's move this morning, while bold, marks a pivotal point for the group. Although, Becker conceded that, "...[Lehman] may be a bit early and that this may not be the absolute bottom for Yahoo's earnings or even its stock price." While that much may be true concerning Yahoo, it's important to mark Becker's upgrade on Yahoo and incorporate it into the "bigger picture" of the technology sector.
Away from the technology sector, a blue chip, old economy name sent the Dow Jones Industrial Average (INDU) to a 400 point gain Thursday. Alcoa (NYSE:AA), the largest aluminum producer, reported earnings of 46 cents per share, while consensus estimates had the company pegged to earn 44 cents. While the better-than- expected numbers from Alcoa were due, in part, to cost-cutting practices, the upside surprise was welcomed nonetheless. Alcoa's earnings report sparked a rampant buying spree in the cyclicals, which powered the INDU higher. And I mention that because it's my belief that the best risk to reward, from the long side, exists in the cyclicals and financials for the intermediate-term.
Concerning the financials, I feel that this group of stocks is perhaps one of the most critical variables in furthering the progress of the broader market and strengthening any rally. In fact, for the S&P 500, Dow and, indeed, the Nasdaq to sustain a prolonged rally, we need to see continued strength in the financials. Readers can measure the progress of the financial sector by monitoring the KBW Bank Sector Index (BKX.X). Within that index includes large money-center banks such as Citigroup (NYSE:C) and J.P. Morgan Chase (NYSE:JPM). Readers will note on the chart below that, despite the Fed's 150 basis point reduction in rates thus far in the cycle, the BKX is stuck in a descending trend and will need to break above roughly 865 in order to break trend. The index still has another 25 points until testing its trend, so keep a close eye on it tomorrow morning following the release of the employment report, which I'll elaborate upon below.
The market will be watching the employment report very closely tomorrow because the Fed and Alan Greenspan will be watching it very closely. The expectations are for the unemployment rate to rise to 4.3 percent. If that number comes in higher-than- expected, the market may actually rally on the news, especially the finance sector, on hopes of the Fed cutting rates before its May meeting. Conversely, if the number comes in lower-than- expected, the market may meet the news favorably. As of late, the market has had the propensity to rally on bullish economic news as the expectations for an economic recovery in the latter half of calendar 2001 increase. So, if the unemployment number comes in lower, the market may perceive that as the economy turning around. And, if the economy isn't as bad as the stock market has been discounting, virtually all growth sectors of the market may rally as shorts cover their bets.
For a quick take on the broader market, I'd like to point out the chart of the S&P 500. The broad market average bounced off the 1100 level for the second time Wednesday, en route to tracing a double-bottom. Whether 1100 holds remains to be seen, but the fact that buyers stepped in yesterday was encouraging. Nevertheless, the S&P 500, like the BKX, is in a severe descending trend and needs to break out above 1175 in order to break trend. That level may prove pivotal in the near-term, and traders should monitor the action as the S&P approaches 1175 in conjunction with the BKX as it approaches the aforementioned 865 level.
The Nasdaq's rally was very impressive Thursday, but the COMPX failed to reach the 1800 level. And I don't think that was a coincidence. My esteemed colleague, John Seckinger, pointed out that the 1794 level marks a pivotal point for the COMPX - the day high Thursday was 1785. Of course, 1794 is very close to 1800, so the latter may suffice in this case. To digress, the point that Mr. Seckinger made was that shorts may become more fearful if the COMPX advances above 1794. If the short-infested COMPX follows-through Friday and advances above 1794, we may see the index move back into its range between 1900 and 2000. Now, I know that Jim Brown recommended not going long any calls for an extended period of time until the COMPX closes above the 2000 level. But, I think that some quick profits can be taken from the long side if the COMPX gains momentum in the form of short covering above 1794 - just remember to book 'em quick.
There are plenty of reasons to be bullish after the 10 percent gain in the Dow and 8.9 percent advance in the Nasdaq Thursday, but I'd like to put Thursday's action in perspective. We've seen these types of moves in the broader market averages since the dawn of the great bear market. That is, time and time again, the market has confounded its participants by displaying rallies of historic proportions. But, I'd like to remind readers that violent, massive rallies are common characteristics of bear markets. The market, as measured by the Dow, S&P and COMPX were deeply oversold going into Thursday morning and the Alcoa earnings report, bullish comments from Dell and the Yahoo upgrade combined to induce fear in the shorts. That fear, in turn, induced short covering (buying). But, when there's fear, to the upside, amongst shorts, the real buyers can't be too far behind. And that's why I suggested that the risk in shorting stocks is increasing, while the potential reward is decreasing and the bottoming process, which has historically taken time, may soon begin.
Furthermore, as we were reminded after the close Thursday, earnings continue to deteriorate in corporate America. Sycamore Networks (NASDAQ:SCMR) and Extreme Networks (NASDAQ:EXTR) both issued profit warnings, which reinforced the difficult telecom dynamic that is still plaguing much of the tech sector. I'm very certain that we'll continue to hear of profit warnings within select tech sectors, but the impact of such warnings is the variable. That is, has all the bad news already been discounted into the share prices of such tech giants as, for example, Cisco Systems (NASDAQ:CSCO)? We must remember that the market is an efficient discounting mechanism, and is forward-looking.
I'm not trying to discount the very much enjoyable rally in the broader market averages Thursday. Indeed, I believe that money can be made from the long side IF the aforementioned metrics line up as I described with the BKX, S&P 500 and the COMPX. There are several reasons to start getting bullish on the market, as Dick Arms recently pointed out. His ARMS Index, or TRIN, is flashing bullish signals which have historically portended market bottoms. The 10-day moving average of the ARMS Index recently rose above 1.5 and EVERY time in the last 20 years it has reached these levels, the market staged a major reversal. Typically, when the ARMS Index rises above 1.5, the market had reached its nadir within 4 to 20 days. When Mr. Arms first opined concerning the spike above 1.5, he said that the market would most likely retest its lows and that's exactly why I pointed out the double-bottom in the S&P 500 Wednesday - that could've very well been the retest.