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Market Wrap

Last Line of Defense Breaks!

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        WE 7-19          WE 7-12          WE 7-05          WE 6-28  
DOW     8019.26 -665.27  8684.53 -694.97  9379.50 +136.24  - 10.53  
Nasdaq  1319.15 - 54.35  1373.50 - 74.86  1448.36 - 16.58  + 24.01  
S&P-100  423.10 - 35.81   458.91 - 33.75   492.66 +  2.54  +   .70  
S&P-500  847.75 - 73.64   921.39 - 67.64   989.03 -   .79  +   .69  
W5000   8083.00 -628.50  8711.50 -601.90  9313.40 - 70.63  -  5.95  
RUT      386.20 - 27.08   413.28 - 27.64   440.92 - 21.74  +  1.59  
TRAN    2332.18 -147.96  2480.14 -172.50  2652.64 - 77.68  - 25.32  
VIX       43.45 +  5.12    38.33 +  8.12    30.21 +  1.08  -  2.15  
VXN       61.17 -  4.83    66.00 +  9.72    56.28 -  1.67  -  1.35  
TRIN       1.44             0.89             0.28             1.18  
Put/Call   1.14             0.64              .77              .66  

It is starting to become a nasty habit with the Dow losing more than -665 points two weeks in a row. The -390 point drop on Friday was not as critical as the actual levels that were broken. I hate to be the bearer of bad tidings but the final bastion of post 9/11 support is now history. The Dow was the last index to fail and it went down in flames. The Dow broke the 8063 post 9/11 reaction low at 3:36 PM and there was not even a blip on the chart when it was passed. Traders watched in shock as the down volume swamped up volume and accelerated into the close.

Chart of the Dow

Chart of the Nasdaq

Volume across all exchanges was 5.394 billion shares. Up volume was only 741 million shares with down volume of 4.062 billion. This nearly 6:1 ratio was bad but analysts are still predicting that things will get worse. The Russell-2000, normally a leading indicator for the broader market lost another -27 points to close at 386 and well off the 465 high from three weeks ago. The standout for the week was the NDX. The Nasdaq 100 still lost ground, -35 points for the week, but only -3.5% when the other major indexes were down over -6%. This would indicate that tech stocks could be the leaders once the bottom is found.

The morning started off bad with Dow component JNJ down -$9 after saying it was under investigation for record-keeping irregularities relating to a factory that makes Eprex. This is not an accounting problem but concerns records relating to the manufacture of the drug. According to all accounts this is a non-event and we are adding JNJ as a call play today. Still the negative sentiment surrounding a Dow component down -$9 set the tone for the markets.

It did not help any that Microsoft finished up their earnings release yesterday with cautious comments about the coming quarter. If the biggest and most Teflon covered tech company could be facing a challenging quarter then what would the rest of the industry be facing. SUNW had positive things to say on Thursday but analysts read between the lines on their guidance and decided that the outlook was worse than they thought. MSFT lost -1.55 for the day and SUNW dropped -26% to $4.24.

Microsoft would have been down more except for some massive buy on close orders for several tech stocks. MSFT saw orders for nearly two million shares at the close. IBM saw nearly one million shares trade, INTC over one million and nearly two million in ORCL. Somebody saw the support in the NDX and decided they wanted to be long tech for Monday. OR, they decided enough was enough without a major NDX drop and they covered their shorts.

Another factor in the sell off was the massive trade imbalance reported on Friday. The trade deficit jumped to $37.6 billion and the largest number on record. This number was impacted in some extent to the fall of the dollar. It now takes more dollars to buy merchandise than it did several months ago.

The economic numbers may be less than desirable but the main number we need to worry about is the cash outflow from equity funds. AMG Data said in the week ended Wednesday $11.4 billion in cash was taken out of equity funds. When you consider more than $1.5 trillion in market cap was lost in the markets in the last two weeks these investors may be considering themselves lucky. The number we hit today on the Dow, under 8000, is exactly where the Dow was in July 1997. Exactly five years of profit has gone up in smoke. This was the worst two weeks for the Dow since the 1987 crash.

The damage this week was not limited. Every sector regardless of previous strength, future outlook, market cap or depth of oversold was spared. The Russell-2000 has died. The SPX/OEX have both died. On the S&P fully 27% of the stocks set new 52-week lows this week. Only 5% of the S&P are above their 200 DMA and only 1% are above their 50 DMA. The bear market has been chewing up company after company and the carnage is far from complete according to many. There are still profits in risk in companies like the home builders and defense stocks and until those winners are dumped with the rest the selling will continue.

I have read and listened to every conceivable version of the fate of the markets today. I have head Dow 11,000 to Dow 5,000 by year end. (yes there are still some diehard bulls) I have heard dire predictions for next week and the possibility for another -600 point drop. When everyone was ready to call a bottom last week it appears that they are now projecting the bottom well out into the future. It appears everyone is trying to go on record as being more bearish than everyone else. This is great news! It means the bottom, if there really is one, "should" not be far away. In reality I think it is farther than even some serious bears may want to admit. There are so many problems that just fixing one or two will not cure the patient. Some of the problems are date specific and cannot be cured next week.

The dollar continues to fall and overseas investors are still repatriating funds and moving out of the U.S. stock market. Margin selling is gaining speed as the hard core who leveraged down on every dip are being wiped out right and left. Funds are selling to raise cash for redemptions as thousands of investors call it quits. The only people not selling are the hedge funds which are covering shorts in expectation of a coming rebound. (remember the buy on close orders on Friday?) The selling is so widespread that it is being felt in rural America. My wife stopped at a large yard sale on Friday. Seemingly everything but the kitchen sink was on sale. The owners husband is a full service broker and she said he was afraid to answer the phone. Every call was somebody liquidating their account. Many had been clients for many years. They saw the handwriting on the wall and were raising cash to downsize their lifestyle.

While that is a sign of true capitulation it also raises a critical point. When the 1987 crash was over millions of investors were no longer in the market, either by choice or by liquidation. When this crash is over there will be far more investors, due to the Internet investing craze, that will no longer be in the market due to choice, bad decisions or forced liquidation. In 1987 almost all investors had brokers to bounce decisions off of. (I know the obvious conclusion here but hear me out.) With the Internet empowering investors to make their own decisions, many with no guidance or education at all, the money flowed and flowed and flowed. The well has now run dry for roughly 60% of the Internet investors if estimates are to be believed. Those investors will not be back any time soon. This is a major hit for those investors, to the wealth effect and to the future market.

Consumption was rampant during the market bubble. Cars, boats, big screen TVs, dvd players, personal computers, etc. Money was easy and the IRAs and 401Ks were an ever growing bank account providing security for the spendthrift lifestyle. Fast forward to the present. Unemployment is very high. Layoffs are continuing to be announced daily. Major corporations are closing factories and reporting massive write offs. Profit projections for 15%-50% growth are being revised downward to +1% to +4%. The world is suddenly not a safe place and fear of flying takes on an entirely new meaning.

Suddenly the term "earnings surprise" has mutated into "surprised if they have earnings". The investing public will likely see the largest bankruptcy in corporate America by Monday. WCOM has gone from offering half the Internet capacity in the U.S. to a $100 billion black hole for investors. WCOM will surpass the prior largest bankruptcy of Enron just a couple months ago. While this is very bad the worst may be yet to come. Even Greenspan warned that there are many more accounting problems in our future. The markets today are reacting to the coming accounting lottery. The top 900+ companies in America have been given till August 14th to begin certifying their financial statements under criminal penalties. Various estimates vary from 10 to 100 companies will disclose accounting skeletons and if you are holding one of these companies when they announce you will win the prize. That prize will be a stock price that could be cut in half or worse overnight. If it can happen to WCOM it can happen to anybody.

This is breeding a lot of uncertainty in the investor world. With capital retention the number one priority the only thing you can do is move out of stocks that you feel are not 100% squeaky clean. Who is that? Even GE has come under fire for possible accounting problems and that means anybody is suspect. It does not have to be a little guy stretching the truth to entice investors to his $5 stock. It can be anyone as we have see recently from the negative news events. The investing public is so scared right now that JNJ dropped -$9 on news that an employee who works in the boiler room filed a grievance suit and the Feds decided to investigate. The stock lost $23 BILLION in market cap in one day. The employee claimed he was pressed to cover up a lapse in a manufacturing process in 1999 and then fired a couple days before a future inspection by the FDA. Suddenly the blackmail possibilities are endless. Is this worth $23 billion? Of course not but it illustrates the fear in the markets.

Where to from here? To use a phrase from Art Cashin, "investors have gone from disappointment to disillusionment and are on the verge of despair." The keyword here is "verge". Despite the massive Dow drops over the last two weeks (-14.4%) most agree we have not seen the bottom. With the failure of the last major psychological level for the Dow, that being 8063, we are free to trade down to 7400 without any serious resistance. Yes, I said 7400. Will we see that on Monday? I doubt it but with the current depth of negative sentiment I think we will get there. With so many analysts calling for massive capitulation on Monday morning I doubt we will see that either. The market never gives us what we expect in the short term but is normally predictable longer term. I will leave the discussion about individual support and resistance levels to Leigh in his Index Wrap this weekend and stick to the general outlook.

I think the severely oversold conditions will produce a rebound soon, probably Monday afternoon or Tuesday. It is a simple technical fact that you can't push stocks down much farther without a relief rally to equalize pressure. The spring will only compress so far! This will only be a trading bounce. With August 14th looming in our future it will be very hard to mount any kind of sustained rally until all the bad news is over. Several readers have asked about the VIX this weekend. The VIX hit a high of 43.79 on Friday and closed at 43.36. This level has not been seen since Sept-24th. Before that you have to go all the way back to the October-1998 crash when it traded as high as 60 to find another surge of this magnitude. Historians know that extremely high VIX readings predict market bottoms almost exactly. The only criteria here is how high is high?

While the VIX was over 43 on Sept-24th it was also over 57 several days before. While it was 43 on Oct 11th 1998 it was over 60 on October 4th. In normal markets a high reading in the mid 30s is enough to bring buyers flocking in from the sidelines. In abnormal markets there is an outside force controlling the markets and the VIX which is an indicator of fear is simply an indicator that fear is rising. Many felt the VIX should have been higher on Friday. I agree. Option expiration held it down. The VIX is calculated on by taking a weighted average of the implied volatilities of eight OEX calls and puts. The options chosen have an average time to maturity of "30" days. This means on expiration Friday the options used are a month in our future and they are not quite as volatile as the current month options. The bottom line, we may see a higher VIX this week but the number itself should only be taken as one of several indicators for the time to buy. The put/call ratio at 1.14 today is another strong indicator of an impending relief rally but it can also move higher. The bottom line is fasten your seat belts and stow your tray tables the ride ahead could still be bumpy!

Enter Very Passively, Exit Very Aggressively!

Jim Brown
Editor

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