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Market Wrap

When is a rally not a rally?

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      03-26-2002           High     Low     Volume Advance/Decline
DJIA    10353.36 + 71.69 10432.86 10276.76 1.19 bln   1953/1205
NASDAQ   1824.17 + 11.68  1843,96  1807.47 1.46 bln   1999/1566
S&P 100   575,17 +  3.50   580.14   571.67   Totals   3952/2771
S&P 500  1138.49 +  6.62  1147.00  1131.61             
RUS 2000  501.66 +  5.27   501.74   496.39
DJ TRANS 2875.37 + 58.14  2878.05  2814.92
VIX        19.79 -  0.73    20.38    19.38
VXN        37.68 -  1.50    39.57    37.64
TRIN        1.10 
PUT/CALL    0.66

When a +71 point gain follows a -354 point loss! This is what we saw on Tuesday when the Dow rallied back from a serious oversold drop of -354 points from the 10635 close on March 19th. The four-day drop culminated with a -146 point dive on Monday and set the stage for today's gains. The positive headline economic numbers prompted some short covering but volume buyers were still absent despite the news.

Economic reports prompting the minor short covering included Consumer Confidence and Durable Goods. With consumers thinking the recession is over the headline numbers soared +15 points. The expectations index rose to 109.3 with 25% of the respondents believing that conditions will continue to improve. This is the strongest number since 1993. The present conditions index at 110.2 is up significantly since the 84.9 low in October but far from the 144.5 number just last August. Unfortunately the internal components declined. The numbers of consumers planning to buy a home, auto or major appliance fell. The consumer held up the economy during the recession but that spending appears to be slowing.

This decreased spending was also shown in the Durable Goods Orders. The headline number showed a larger than expected increase but the main contributors were aircraft and aircraft parts as well as defense orders. These orders will not continue and do not represent a rebound in the business economy. Semiconductor orders fell -8.9% and computers fell -3.1%. When the aircraft and defense orders are subtracted from the index the real durable goods orders fell last month. While the levels are still over the Q4 recession levels they are still not healthy.

You can see from those two reports that the real health of the economy may be improving over the long term but the rate of improvement is very much in question. This should make most investors look at the minor market gains today with skepticism. The bounce was mostly short covering on the headline numbers and very little real investor buying.

Another reason for the gains came from a set of mixed comments from three Fed members. Two of them said the Fed was in no rush to raise interest rates while one, Blinder, said rates should go up soon. In balance the market paid more attention to the positive comments than the comments by Blinder. Homebuilders jumped for some good gains on the assumption that mortgage rates could remain low for longer than previously expected. The Fed funds futures fell to only a 60% chance of a 25 basis point hike in June instead of the more than 80% chance last week. The big winner by far was NVR which gained a whopping +$22 to $322.25. Sorry guys, it is not optionable!

There was still the normal run of story stocks impacting specific sectors with major moves. Network Associates (NYSE:NET) said the SEC had launched an investigation into the way the company booked revenue in 2000. The company said the inquiry was probably based on the resignation of the CEO, CFO and President in Dec-2000. Each resigned just as NET announced a change in accounting practices and a revenue shortfall of $120 million for that quarter. This announcement put the MCAF acquisition on hold after NET shares fell -2.77 or -11%.

EDS fell over -$4 after Sanford Bernstein lowered its rating on worries that EDS would miss earnings on April-22nd. The analyst said new business from current clients would not be enough to offset the lack of new customers in the 1Q. Merrill Lynch called the drop a "beautiful buying opportunity" and said they believed the company would hit its earnings target. IBM failed to hold the opening bounce and closed -$3 off the days high. IBM gets a substantial portion of its revenue from services contracts as well and any concern about EDS would be a concern for IBM. Rumors are starting to fly that IBM may be challenged and could miss estimates. They have been meeting estimates by cutting costs and buying back shares for over a year and that tactic only lasts so long. Remember, HWP may also have a shortfall in services income for the quarter.

Waste Management (NYSE:WMI) was all over the map today as the SEC filed suit against the former WMI management for cooking the books and inflating profits. The company was quick to point out that this was against the "old" Waste Management and not relative to current conditions. The stock ended the day down only a penny. Unfortunately ROOM fell slightly more than a penny, -8.59 to be exact, after Travelocity said it was buying Site59 for $43 million in cash. The acquisition is directly aimed at EXPE and ROOM and capturing market share from these companies.

CIEN said it was cutting 650 jobs (22% of its workforce) and said it would take a $360 million charge. They will also take a charge of as much as $225 million for excess inventory in an effort to return to profitability. Let's see, if you write off $225 million in inventory and then sell it for $50 million at fire sale prices, can you claim that $50 million as "profits"? Carrying this to the logical extreme why not write off everything in one quarter and then claim profits against a zero book value from then on? Don't laugh, it is not that far from reality.

Show me the money. This is what real buyers will be saying before they commit capital to this market. With the first quarter earnings cycle only two weeks away the uncertainty about results is keeping the volume very low. The markets are trending down despite the economic headlines. In Greenspan's speech tonight he mentioned the quality of corporate earnings several times. With the Enron, Global Crossing, Network Associates and Waste Management accusations still flying regulators are questioning new accounting rules. Some of these rule would seriously cripple "earnings" for many tech stocks. A PE of 50 could become a PE of 200 overnight if the rules were changed. This accounting cloud will depress the markets for sometime.

Speaking of clouds there is a huge thunderstorm brewing in the deep south. DEEP South. Argentina is quickly self-destructing. This has been underway for some time but it is quickly getting worse. The currency is barely suitable for wallpaper and unemployment is well over 20%. The government is in chaos and has no plan. One analyst today said the current civil unrest is likely to turn into serious trouble soon. Because this has been coming for many months most of the impact to the U.S. markets has already been seen, factored and forgotten. However the severity of the current crisis appears destined to impact all the surrounding countries even more than previously anticipated and that could ripple all the way back to Wall Street. Several multinational companies have already warned that the economic weakness in South America would impact their 2002 earnings and more will follow. I don't think the Argentina crisis is over for us. Just an opinion.

Many traders are not convinced the market bottom is behind us. The short interest on the Nasdaq rose to 4.01 billion shares in the report released today. Considering the very light volume the last week or two the majority have not decided to cover just yet. Still there is a very strange divergence occurring in the market place. The VIX hit another new 52-week low intraday despite the -146 point Dow drop on Monday. Not a good sign. However the internals are showing some positive indications. The new highs continue to beat new lows despite the down trending markets. The NYSE highs beat lows 113/79 and the Nasdaq was even stronger at 131/42. Advancers also beat decliners 5:3.

On Sunday I warned about buying the Nasdaq under my entry point of 1875 and suggested shorting it under 1825. It closed today at 1824, right at the support level I mentioned. I suggested staying out of the S&P until it traded over 1155 and to short it under 1140. It closed today at 1138. Confused? The market internals are positive but the markets are still trending down along with the VIX. You should be confused. It is clear there is considerable confusion among investors, retail and institutional alike. Not enough confusion however to put volatility back into the market. Complacency reigns!

Most investors feel the markets will go up as the recovery continues. They are just divided on when that recovery will occur. Most analysts are now pointing to 2003 instead of 3Q/4Q this year. The complacency comes from indifference. Despite the increase in the Nasdaq short interest it appears that most investors are content to just sit on the sidelines and wait. Their volatility is zero. Others are content to simply nibble on every dip and slowly add to their portfolios, confident in a future recovery. Their volatility is minimal. This picture is vastly different from the February bounce when optimism abounded. Reality is slowly sinking in and investors are beginning to realize the rebound may be lethargic instead of robust. The lack of buyers is simply due to a lack of interest. Historically a sell off occurs between April-15th and May-15th more often than not. Recently 52-week lows on the VIX produced a -10% to -20% drop in the S&P over the next 45 days. A low VIX prior to the spring sell off? Hmmmmm.

Last three 52-week VIX lows:

8/28/00 18.13 S&P = 1523 dropped by -218 (14%) to 1305 in 45 days
7/16/99 17.70 S&P = 1418 dropped by -151 (11%) to 1267 in 23 days
7/17/98 16.78 S&P = 1188 dropped by -249 (21%) to 939 in 43 days

(7/2/2001 low was omitted due to 9/11 distortion but 13% drop had occurred prior to attack)

The first key point here is that extreme complacency is followed by prolonged selling. The second key point is that we only know these were 52-week lows by looking backwards in history. The current VIX at 19.75 is still above these historical numbers and still dropping. This means we have not hit the bottom on the VIX yet. It could be next week or it could be next month, we don't know. This is exactly what large institutional investors are waiting for. They pay millions for long term technical analysis in order to time their entries into the markets. That technical analysis is suggesting that a better entry point lays ahead. Therefore they are content to sit and wait. It is interesting to note that the VIX low may be occurring significantly earlier this year than in the last four years due to the recession impact and positive investor expectations. Does that mean it could drop below established norms? Could be.

Armed with the above knowledge what should an informed investor be doing? Protecting long positions and waiting patiently for the coming entry point. Until then should a rally break out we need to wait for confirmation before boarding the train. That confirmation would be a break above 10500/1875/1155, none of which is likely to happen tomorrow! Remember my comments on Sunday about buying the close on Thursday. I would only buy it if there is a post 3:PM rally underway. The light volume today after the -354 point four day drop is worrisome. The Thursday close strategy should only be undertaken by nimble traders. Historically bullish post Easter trading can evaporate instantly should earnings warnings prevail.

Enter VERY Passively, Exit Aggressively!

Jim Brown
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