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Rejuvenating Rebound, But Will It Last?

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        9-19-2001          High      Low     Volume Advance/Decline
DJIA     8759.13 -144.27  8945.47  8480.21 1.67 bln   1228/1926	
NASDAQ   1527.80 - 27.28  1568.22  1451.31 1.83 bln   1440/2300
S&P 100   518.85 -  7.95   529.92   500.87   Totals   2668/4226
S&P 500  1016.10 - 16.64  1038.91   984.62             
RUS 2000  503.20 -  8.46   413.44   391.38
DJ TRANS 2165.86 - 51.21  2247.68  2104.63
VIX        43.22 +  0.72    47.62    40.80 
VXN        76.93 +  2.19    78.28    72.84
TRIN        0.88 
Put/Call    0.67

Rejuvenating Rebound, But Will It Last?

Although the broader market averages finished in the red Wednesday, they managed to climb well off their session lows. The rebound into the close was a refreshing change from the tedium that had become the steady grind lower. But, it remains to be seen if Wednesday's late-day buying interest carriers over into Thursday's session.

Wednesday's early weakness stemmed from the realization of the economic impact of last week's terrible events. Although market participants knew going into this week that business was adversely impacted, the severity of such was the unknown. But the increasing number of lost jobs and earnings warnings Wednesday morning revealed just how economically devastating last week's attacks actually were.

The airline industry is revealing just how much financial damage was realized last week, and how difficult it's going to be to move forward. Boeing (NYSE:BA), who's seen its shares drop some 25 percent following the attacks, reported Wednesday that it would cut up to 30,000 jobs from its commercial airline division. The company will reportedly start issuing pink slips in the next few weeks, with the majority of layoffs to begin in about two months, lasting through the end of 2002. A Boeing spokesman said the layoffs would occur across every level of employment, geographic location, and airplane models. But to reiterate, the layoffs will be concentrated in Boeing's commercial airline division, which currently employs about 94,000.

On top of Boeing's cuts, United Airlines (NYSE:UAL) said it plans to cut about 20,000 jobs. To put the number in perspective, the airline employs about 100,000 people in all! To make matters worse, American Airlines (NYSE:AMR) announced Wednesday evening that it would be forced to cut at least 20,000 employees.

Counting the job cuts announced earlier this week by Continental (NYSE:CAL) and US Airways (NYSE:U), Wednesday's announced job cuts brought the total number to about 100,000. That's 100,000 lost jobs at major airline-related companies!!! These lost jobs only add to the pain of what the United States lost last week, and their trickle down impact on the economy will be felt for some time to come. Hopefully, Congress will soon pass a relief package for the airline industry.

The negative news, however, wasn't confined to the airline industry Wednesday. Adobe (NASDAQ:ADBE) reported third-quarter numbers that fell short of expectations and guided lower for fourth-quarter expectations. The company's results were not related to last week's attacks. Instead, Adobe cited weakness in Asian markets. Shares of Adobe lost $4 Wednesday.

Eastman Kodak (NYSE:EK), a Dow Jones Industrial Average component, lowered its third-quarter earnings expectations Wednesday morning. The company did cite the adverse effects of last week's events. In addition, the company hinted towards announcing job cuts in the near future. Shares of Kodak shed $2.22.

But not all news was bad. McDonald's (NYSE:MCD), another Dow component, reported that its third-quarter results would come in ahead of expectations. The company said that it would earn about 2 cents more than Wall Street had expected, before accounting for currency translation. The continued slide in the dollar versus the yen and euro might actually raise McDonald's earnings further for the current quarter.

But the declining dollar is a double-edged sword. While its a positive for those multinationals that export a great deal of business overseas, it also implies a flight of foreign capital out of the U.S. markets. In fact, some of Wednesday's earlier selling of equities could've been from foreign accounts. It was only when the dollar stabilized Wednesday afternoon that the major market averages were able to rebound from their lows. This dollar dynamic is worth monitoring insofar as short-term traders are concerned. While a gradual decline in the dollar wouldn't necessarily be a bad thing, panicked selling of dollars would cause further weakness in stocks. The chart of the U.S. Dollar Index below, which was retrieved through QCharts using the symbol DX01Z, depicts its weakness in past sessions. What the bulls don't want to see is accelerating weakness in this index.

The mention of the price action of the U.S. dollar may be foreign to some readers. However, realize that is a most important pillar of the economy. And bonds are, too! The yield curve steepened Wednesday, which would normally imply an economic rebound and the inflation that usually accompanies growth. But, in light of the current climate, the steepening of the yield curve is artificial by some measures. It would appear that bond market participants are selling longer dated treasuries (30-Year) in favor for the relative safety of shorted dated treasuries. This flight to quality has been a thorn in the side of the Fed's interest-rate-cutting actions this year because the short-end of the yield curve continues dropping below the rate of Fed Funds. The flight to short-term treasuries has also weighed heavily on stocks, and will continue to do so as long as market participants shun the risk that is currently associated with equities.

There's a reason for my detailing the dollar and bonds as it concerns Option Investor readers. It is my belief that Wednesday's late day rally was no more than short covering induced, and I'll try to reinforce that notion below. We're sure to witness additional short covering rallies between now and whenever the bear market is finally over. They will be tradable just as Wednesday's was. But the critical step in attempting to trade from the bullish side is timing. By monitoring the price action of the dollar and bond market, traders will be better prepared to attempt gaming the long side.

There's no real catalyst, over the short-term, for the "real buyers" in the market to be buying. And I define "real buyers" as the institutional types, such as mutual funds, hedge funds, and pensions. There are, however, an overwhelming number of sellers in the market, such as shorts, insurance firms raising cash, foreign accounts exiting U.S. markets, margin calls from brokers, and mutual funds meeting redemptions. That leaves shorts covering their bearish bets as the only en masse buyers in the market. But the shorts won't cover until after the selling has subsided and their scared into doing so. (It's my opinion that that's what happened Wednesday.)

This is complicated, I know, but I'm trying to give my readers some value. Try to keep it in the simplest terms of supply and demand. If foreign accounts are selling, as measured by a weak dollar, there's less of a chance for a rally in stocks. And a continued exodus to the short-end of the yield curve leaves less demand for stocks, too. But if the dollar is stable and bonds are, too, the shorts will be on alert and more likely to cover.

I think it was nothing more than short covering Wednesday that carried the broader market averages higher. By any measure, the Nasdaq, Dow, and S&P were greatly oversold. Oversold doesn't necessitate a rally, but it can put bullish traders on alert to possible upside. It's detecting the shift in supply and demand (Read: Timing) that is the tricky part, and that's where the dollar and bond market come in.

The reason I think Wednesday's rally was only short covering was because of its velocity. The 2-minute chart of the Nasdaq-100 (NDX.X) below reveals a sharp, short rally in the final hour-and-half of trading. And let it be known that "real buyers" DO NOT buy stocks this way! They don't chase 'em higher! They sit on the bid, absorb supply, and slowly, steadily carry markets higher.

If Wednesday's reversal was no more than short covering-related buying, then the lift was somewhat artificial. That's not to say a short covering rally can't last for a few days. In fact, we may see some follow-through going into Thursday's session, and possibly Friday morning. But I don't think that many traders will want to hold bullish positions over the weekend, fearing military action in Afghanistan. Having said that, I think we'll get another solid entry point into put plays sometime between Thursday morning and Friday afternoon. My sense is that Wednesday's lows will eventually be taken out.

On a final note, I send my prayers to those brave Americans who are on their way to defend our freedom. May you return home safely!

Eric Utley
Option Investor

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