Option Investor
Market Wrap

Not Out Of The Woods Yet!

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        WE 9-28          WE 9-21          WE 9-14           WE 9-7
DOW     8847.21 +611.40  8235.81 -1369.7  9605.51 -   .34  -343.90
Nasdaq  1498.80 + 75.61  1423.19 -272.18  1695.37 +  7.67  -117.73
S&P-100  533.10 + 41.40   491.70 - 66.88   558.58 +  4.69  - 23.51
S&P-500 1040.94 + 75.14   965.80 -126.74  1092.54 +  6.76  - 47.80
W5000   9562.93 +662.48  8900.45 -1203.9 10104.44 + 37.95  -448.60
RUT      404.87 + 25.98   378.89 - 61.84   440.73 -  4.46  - 23.37
TRAN    2193.99 +139.15  2054.84 -621.65  2676.49 - 36.65  -100.27
VIX       35.19 - 13.08    48.27 + 13.67    34.60 +   .24  +  6.51
VXN       65.19 - 12.54    77.73 + 13.89    63.84 -  1.61  + 12.59
TRIN        .73              .60              .68             1.25
TICK       +995              +21             +100             -113
Put/Call    .61             1.27             1.01              .84

The Dow gained +611 points for the week and retraced 44% of the prior weeks loss but very few traders expect it to last. The Dow ended September with a +166 point Friday gain but a -15.7% loss for the quarter. This was the worst quarter since Q4 of 1987. The Nasdaq lost a whopping -30.7% for the quarter for the second worst quarter ever. The worst quarter was 4Q-2000 when it lost -33%. According to fund analysts over 95% of U.S. stock funds have lost ground with many down over -50%. The broad market, as tracked by the Wilshire 5000, lost $1.14 trillion in September and -$2.25 trillion in the third quarter.

Can the markets still be oversold after a +44% retracement of the prior weeks drop? Yes, they can but that does not mean they are ready to rock next week. The rally on Friday was "reported" to be specifically from portfolio rebalancing. This is when funds which advertise certain percentages of cash, bonds and stock in their portfolios, must buy/sell to maintain those averages. A fund with a 70/30 mix of stocks/bonds could have seen its stock holdings drop significantly in the third quarter. If they had $10 billion under management that would equate to $3 bln of bonds and $7 bln of stock. If that stock position had fallen to $4 bln then bonds would have to be reduced and stocks increased. That would equate to selling $1 bln in bonds and buying stock with the cash.

According to several analysts this quarter required more balancing than any other quarter in recent memory. The buying was widespread with small and mid caps getting special attention. Managers looked to them as not "highly visible global targets" likely to attract a terrorist attack. There were not a few big winners but more of a general broad market gain. Advancers beat decliners on the NYSE by almost a 4:1 margin and better than 2:1 on the Nasdaq. Volume was still anemic at 1.6 bln on the NYSE and barely two bln on the Nasdaq. There was no conviction and no "get me an at any cost" buying.

The economic reports encouraged some traders to tip toe back into the markets but they were in the minority. The GDP report actually came in higher than expected at +0.3%. Most analysts expected a dip into negative territory and the first quarter of retraction in years. This is of course a picture of the 2Q economy, long before the WTC attack. 3Q capital spending continued the down trend from the 2Q and it is now almost impossible for anyone to expect a positive GDP in a post attack economy. Consumer sentiment also fell to 81.8 for the final September report which was only slightly below the 83.6 initial reading. Still it was significantly down from the 91.5 number in August.

The sentiment number is closely watched by the Fed and is expected to fall even further. Critics are going to have a hard time building a case for rising patriotic sentiment when employers are handing out hoods, face masks, gloves and flashlights along with instructions on how to escape a disaster. These supplies and instructions are for the lucky employees who did not get pink slips instead. The government is now warning that travel overseas could be very dangerous, another U.S. attack could be eminent, U.S. planes can be shot down and biological/chemical attack concerns are increasing. How can that in any way build consumer sentiment? Still the Fed is likely to cut rates again on Tuesday in order to continue stimulating the economy. Also the Fed has increased the amount of liquidity they have been putting into the system in the last week. Initially after the attack there was a huge infusion but then they pulled back a little. Conditions must have gotten worse because the infusion rate jumped significantly on Thr/Fri.

The liquidity may be used to hold off further problems in the brokerage community. Two brokers with over a 100,000 accounts were closed this week for failing to meet margin calls. The circumstances were exceptional with GENI stock being the primary cause. It fell from $18 to under $5 and trading was halted by the Nasdaq until the drop was investigated. Millions of shares of this stock had been borrowed by Miller Johnson from another unnamed broker on the East Coast and then reloaned to short sellers among their clients and other brokers. When the stock fell from $18 to $5 there was a sequence of margin calls which eventually fell on the first firm to cover. They were unable to produce the cash and closed their doors. That default then fell on Miller Johnson with a margin call for about $60 million. They had insufficient capital to cover the call and were forced by the SEC to discontinue operations. Customers could sell stocks they owned but could not open any new positions. The company is in talks with several larger brokers including Dain Rauscher and Fahnestock regarding a bailout. Miller Johnson oversees $12 billion in customer investments with over 100,000 accounts. This is exactly what the Fed is trying to prevent. A breach of confidence in the financial system which could cause a run on banks and brokers. Miller Johnson is not a high profile name but let this happen to somebody like Ameritrade and things could get worse quickly. There are undoubtedly many more "unreported" problems in the system that were caused by the recent market drop and the Fed is working behind the scenes to prevent a disaster.

The SEC extended for the second time the deadline for allowing free market stock buybacks. The deadline is now Oct-12th. The fact that they extended it again is a warning to me that things are still risky. They obviously need the floor under the market that unrestricted buybacks provide. There is no doubt that they were instrumental in providing a positive stabilizing influence this past week. The last I heard over 200 companies were taking advantage of the relaxed rules and probably many more were simply unreported.

The Fed meets on Tuesday and is expected to cut rates for the ninth time. They will be cutting not only for the U.S. economy but for the global economy. The title, "worlds banker", was never more appropriate. The global economy had been slipping into recession before the attack but almost every major country was betting on a quick U.S. rebound to pull them out of the drop as well. In a post attack economy they now realize that the U.S. is not going to be coming to their rescue with a massive rebound anytime soon. By all accounts it will easily be 2Q or 3Q of 2002 before the U.S. is going to be seeing aggressive growth again and this is the kiss of death for many countries that depend on us. Greenspan has to continue to act on the rate front to send the message to the world that he will get control of the problem quickly. What he is afraid of is an over stimulation event. Just like he went two rate hikes too far and created this problem he is afraid of going two cuts too low and creating rampant inflation and an excessive unsustainable rebound. He will be cussed by the markets if he only cuts 25 points. After eight cuts however another 50 point drop could also be seen as Fed fear over something the analysts have not yet factored into the picture.

Either way the Fed will be the highlight of the news on Mon/Tue. After that the corporate earnings warnings will be flying fast. As of Friday we had only seen 577 Q3 warnings compared to 622 for the last quarter. First Call went on record saying they expected Q3 to still set a warnings record. That means we could see over 100 warnings in the next two weeks. Many analysts feel that the WTC disaster is a "get out of jail free" card for the corporate world. Those who have not warned can throw every junk item on their balance sheet into this warning and blame it on the terrorists. Since many companies do not report monthly numbers it would be impossible to determine what their business looked like in the two months prior to the attack. The performance for the "quarter" would be all that is reported. Smoke and mirrors to deflect negative investor sentiment. Many may actually be waiting for the Fed announcement hoping to slide in unnoticed in the press. Another problem we will see is the lack of guidance. While it was getting harder to get guidance from tech companies before the disaster it will be next to impossible to get it now. Everyone will take advantage of the confusion on the economic front to avoid being held accountable to a guesstimate for 4Q.

Sony (SNE) was one of the biggest companies to use the terrorist excuse last week. On Friday they said profits would fall nearly -90% from the July estimate of $755 million to $84 million partly as a result of the attack. This was down from the April estimate of $1.3 billion. Now that is a serious shortfall and while a week of missing sales would hurt I can't see the connection to that large of a drop. If anything consumers staying home could equate to more TV and game sales eventually. My point is simply this. The global economy was already in the tank and betting on us. The quarter is over and it is time to confess and it will not be pretty.

A leading indicator for the quarterly results was the warning by UPS on Friday that shipments had declined by more than 10% since the attack. Yellow Freight also warned that profits would be cut in half by falling shipments. Equipment rental companies, temporary staffing agencies and chemical companies were all warning that business had dropped significantly since the attack. Parts manufacturers were seeing cancellations in orders for components in almost every sector. Many economists and major companies had previously gone on record saying that the economic slowdown was the sharpest anyone had ever seen. Unfortunately this was last quarter and well before the September event. Those benchmarks for "worst ever" will obviously need to be revised.

The coming week in the markets is likely to be very tough. The month of October is typically known for the biggest drops. This is because summer is a slow time for business and the October earnings report this. The last quarter was the worst quarter ever for the Dow and the second worst for the Nasdaq. This could temper any further losses to some extent but the odds of another negative market event are very high. The +611 point gain for the Dow last week relieved much of the grossly oversold conditions. The index is ripe for profit taking with some companies showing significant gains since black Monday two weeks ago. The VIX has come back down to almost exactly where it was the Monday before the attack and the put/call ratio is neutral. The retail investor has drifted back into complacency. The window dressing/rebalancing week is over and everyone is holding their breath. Five of the last seven days the Nasdaq has bounced off resistance at 1500. There is no overwhelming desire to be in the markets until after the October earnings are known.

With all the pessimism about the future economic outlook any good news may look like a life boat on the Titanic. Investors could seize on that hope. Still, the odds for bad news greatly outweigh chances for good news over the next two weeks. Once the first two weeks of earnings are over I would suspect we will know what the bottom was for October. Until then I could easily see the 8000 level on the Dow tested again as well as something below 1400 on the Nasdaq. Friday the 21st was a buying opportunity for long term stock investors and leap buyers. Last week was a great trading rally. If you missed both you should be getting ready for another buying opportunity. The rebound off any serious October dip could easily set new records but a word to the wise. Don't buy the first dip. We want to look for the next washout, not the next dip. I doubt it will come this week and as a betting man I would look for it between the 10th and 19th. This week will best be traded on the sidelines and on paper. Patience is a profitable virtue! Profit from it!

Definitely, enter passively, exit aggressively!

Jim Brown

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