Option Investor
Market Wrap

When is a Retest Complete?

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      07-02-2002           High     Low     Volume Advance/Decline
DJIA     9007.75 -102.00  9135.82  8960.54 1.71 bln    687/2334
NASDAQ   1357.85 - 46.00  1396.25  1356.03 2.66 bln    887/2630
S&P 100   470.11 -  8.85   479.59   468.24   Totals   1564/4964
S&P 500   948.09 - 20.56   968.65   945.54             
RUS 2000  432.84 - 14.89   447.73   432.53
DJ TRANS 2619.88 - 80.00  2709.01  2617.11
VIX        33.69 +  3.13    34.64    31.33
VXN        59.57 +  2.12    61.93    58.95
TRIN        2.33
PUT/CALL    1.08

The intraday reactionary low for the S&P on 9/22 was 944.75. The same low for the Dow was 8062.34. The low on the broadest index of all, the Wilshire 5000, was 8722. Today one of those levels came very close to following the OEX, NDX and COMPX into the record books. The SPX dropped to a low of 945.54 and came within three points of the 944.75 low three times. All eyes were riveted to the index as each sell off attempt failed.

Chart of the Nasdaq

Chart of the Dow

The day started out bad and got worse. Almost every major tech sector was hit with a barrage of downgrades and earnings warnings. Morgan Stanley led the charge with a downgrade of 16 chip equipment stocks. Morgan said chip-sector capital spending will drop more than 20% for the year and forecast an increase of only +20% next year. Both estimates were even worse than previous forecasts. They said the recovery is underway but growth and earnings estimates were unrealistic. This was just the beginning of the bad news for the morning.

Prudential cut estimates of KLAC saying growth estimates were overly optimistic. Salomon Smith Barney cut NSM saying the PC market was weaker than previously thought and the mobile phone business may soften. They also said NSM was seeing a slow down in flat panel components. They said the buildup of inventory was troubling and any increase in orders would go towards reducing the buildup and not new production. They also cut RTEC to a hold citing competition concerns and uncertainty.

All in all this is the deathblow for semiconductors. According to First Call the consensus revenue forecasts for chip equipment makers for 2003 will grow by +40%. According to analysts this is highly unrealistic when measured by the capital spending plans of chip makers and the IT sector. With growth prospects now at +20% and dropping these 2003 estimates will soon be dropping like a rock. This makes the already overvalued chip companies even more pricey. Morgan Stanley said it was increasingly doubtful that the chip makers would actually spend the money budgeted for capital improvements. The SOX lost -5% and closed at 1998 lows.

To further complicate matters Merrill slashed estimates on PC makers and estimates for PC demand. Merrill said its growth prospects for PC demand were cut to +2.5% this year from 10.5%. They cited weakness in state government spending, lack of corporate spending and increasing signs of decreased consumer spending. They only cut estimates on Dell by -4% claiming it had a strong competitive position. Worries continue however for IBM, HPQ, GTW and companies that depend on them for sales. Intel closed at 16.56 and a low not seen since April 1998.

Communication chip companies were caught in the downdraft as well with QCOM, MOT and NOK fighting for market share of a market that could be shrinking instead of growing. These companies have been making chips and phones as fast as possible and inventory levels are suddenly spiking as demand slows. Looks like a common thread across all the tech sectors! SSB also cut estimates for CSCO and EXTR. The analyst said it appeared the summer doldrums came a month early to the sector citing flat sales. They cut growth estimates for CSCO to +1% for the July quarter and slashed revenue estimates by -$600 million. He warned that if Cisco was unable to build an order backlog in July then the October visibility would be seriously diminished. According to the analyst this backlog was not happening. Due to seasonal trends June is when orders accelerate for the sector and those gains did not appear.

The software sector was not spared with group downgrades by JPM. RATL and ADVS both warned and that triggered another wave of selling. SYMC, CHKP, MVSN, PSFT and SEBL were among those downgraded. The $GSO closed at 101.54 and an all time low. MSFT was not mentioned in the downgrades but finished at $51.44, down -1.22. The company did not warn and is at the lower end of its current trading range. We added it as a call play tonight on the rationale that any rally on Monday would see money going into bigcap techs because of their high liquidity. Enter it on any weakness on Friday but be aware of the weekend event risk.

The storage sector took it on the chin after Lazard Freres started coverage on BRCD at "sell". Calling the expectations unreasonable and valuations unjustifiable they set a price target at $12. BRCD lost nearly $2 to close at 14.29. ELX closed at 19.77, down only -.76 cents but the old EMLX has lost over -20% since moving to the NYSE on June-24th.

The scandals just keep coming. The big news today was that troubled Vivendi may have tried to pull some accounting tricks and the stock dropped -20% to close at 17.76. This does not surprise market watchers as more and more analysts are saying the bubble gains fueled unrealistic expectations and the crash has caused many to try and cover up those problems with bogus accounting. First Call, the keeper of earnings estimates, said that they foresee more scandals ahead as the SEC takes a more detailed interest in company financials. The warning flag is out and those with problems know their days are numbered. They can either come clean on their own or be found out by the scores of independent researchers currently ripping financials apart. Either way the next quarter will be full of surprises.

Despite the unknown there are plenty of problems. Chuck Hill of First Call said the current second half earnings estimates are unrealistic and could come down at an alarming rate. Already the 3Q has seen estimates drop from 22% to 17% and should fall much further. He feels analysts are behind the curve and will race to catch up as the 2Q earnings are announced. Chuck sees the second half as choppy at best with no real growth until 2003. What a cheerful outlook! According to First Call the warning ratio is 1.2:1, warnings to affirmations. Earnings begin next week and unfortunately many of them may have lowered guidance. This is not a positive environment for a rally over terrorist fears.

Speaking of terrorist fears the government went on record again with another global warning for the coming weekend. They caution about attending crowded events both here and abroad. This is the number one weight on the market today. The fear of the unknown. The S&P closed only four points away from the 9/11 reaction lows and there were several attempts to rally from that level. They all failed. The market appears determined to move lower on the earnings, accounting and terror problems but this selling urge should dissipate some on Monday. It may not be gone but the normal ebb and flow of the markets should return. With the Nasdaq at a five year low and the continuing flood or warnings and downgrades it will not be the Nasdaq that races to the rescue. It is already below the 9/11 lows and still dropping. 25% of the Nasdaq 100 are at 52-week lows or lower.

The event risk will be the predominate mover of the markets on Wednesday. There is no way to factor into already severely oversold markets another attack with massive deaths. The declining volume tells the tale. On the NYSE the down volume was 1.5 billion and the up volume only 182 million shares. Nearly a 10:1 ratio. If you subtract the 820 million shares of WCOME traded on the Nasdaq you are left with 1.6 billion down volume and 229 million shares of up volume. I have not heard the word capitulation as much this week since the sell offs have been gradual and orderly but the better than 7:1 down volume should be a clue. Advances were severely beaten by declines 1564 to 4964 on a combined basis.

Where am I going with this? You can't factor in the terrorist problem but you can factor in the severely oversold conditions. What I expect is a very extreme move on Monday. Up or down we should move very fast. Several readers have asked about a straddle or strangle. We know there will be a multiple hundred point Dow move in at least one direction. Using the DJX because they are cheap options you could do a July-90 straddle for $4.50 net debit. (2.35 call and 2.15 put) However this would require a significant move to break even. The 88/92 strangle would make more sense at a net debit of $2.85. You would have less invested but still need a significant move. Using the OEX options the numbers get even more out of line with the 470 straddle costing over $26.00. The best vehicle in my opinion is the QQQ with narrow strikes and cheap options. The 24.00 straddle is only $2.40 and the 23/25 strangle is only $1.50. It is highly likely that the QQQ could see a 2.5 point move in either direction which would make this strategy profitable.

However, regardless of those options above the best strategy would be to just wait. Without any tragic event over the weekend the markets are likely to rally back to resistance again. The odds are better than 50/50 that once the relief rally is over the markets will fall victim to the earnings problem and roll right back over again giving us a great entry point for another directional put play. Should we be attacked again the markets will crash and push us into another reaction low like we saw in September. This would provide another opportunity for a long directional play on the rebound. Both of these scenarios require ready cash to play. If your risk capital is tied up in a straddle or strangle and you find yourself trying to wish/hope the markets back to a breakeven position then you can miss out on the best play of all. To me the event risk is not being in cash with an open mind and ready to capitalize on whatever the markets give us on Monday. Do you really want to spend your holiday worrying that a Monday relief rally will not occur? Do you want to spend the weekend hoping for an attack where innocent people die? I doubt you will answer either question with a yes. Take the weekend off and relax with your family. You never know if the next attack will hit somebody YOU know. Leigh Stevens worked at Cantor Fitzgerald and lost dozens of friends in the WTC attack. For millions of us the attack was a news event. For thousands it was very personal. Let's just pray the weekend is peaceful and wait to worry about the markets until Monday.

Enter Very Passively, Exit Aggressively!

Jim Brown

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