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Market Wrap

To The Moon Alice

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07-24-2002               High    Low     Volume Advance/Decl
DJIA     8191.29 +488.95 8202.02 7532.66 3218 mln  1949/1269
NASDAQ   1290.23 + 61.18 1290.40 1192.42 2207 mln  2003/1443
S&P 100   419.98 + 23.23  420.48  384.96   totals  3952/2712
S&P 500   843.43 + 45.73  844.32  775.68
RUS 2000  378.56 + 14.57  378.56  354.11
DJ TRANS 2183.92 + 23.57 2190.48 2090.32
VIX        45.29 -  5.19   56.74   44.92
VIXN       65.59 -  0.80   69.73   64.55 
Put/Call Ratio 0.87

To The Moon Alice

Today started off looking like a continuation of the recent plunge. Support at 7400 on the Dow looked sure to be tested. We traded as low as 7532.66, before rallying back more than 650 points, all the way to 8191.29. The Dow closed up 488.95 points, for the second largest point gain ever. A rumor that the Federal Board of Governors might hold an emergency meeting to lower interest rates may have been the catalyst. One other theory advanced by our Senior Market Technician, Jeff Bailey, is that the bearish count on the 5-year Treasury YIELD of 3.30% had been achieved, possibly triggering an institutional buy program on stocks that were rotating cash out of bonds and into stocks. The thinking goes that some institutions moved their cash, generated from selling equities, into treasuries, earlier this year when the YIELD was higher. When the YIELD reached its bearish vertical count this morning it may have triggered some models away from the 5-year YIELD to lock in gains on the price, and shift the cash back to stocks. There are plenty of theories as to what caused this rally, but I suspect it is a result of the coil being wound a little too tightly the last couple of weeks. Remember the Dow had given up more than 1800 points since July 5th, including this morning's low. A bear market rally, retracing half of that move, would amount to a 900-point bounce.

Chart of the Dow Retracement

The bounce from the 7500 range wasn't that far off from predictions of 7400, which had permeated the market. These predictions looked back to support in January and August of 1998, as well as October of 1997. The rallies following these support levels in 1998 both reached the 9000 mark.

Monthly Chart of Dow

The S&P 500, which had lost more than 100 points over the last four days, rallied back 45.69 points, making back almost half its losses since last Thursday, to close at 843.43. The S&P had fallen through support at both the 900 and 800 levels in a very short time and looked ready to test the 700 mark soon. But certainly not today.

The Nasdaq Composite ($COMPX) also looked ready to set new lows, breaking support at 1200 as it traded down to 1192.42 to start the day. The index followed the rest of the market and finished the day up 61.18, more than 5%, to close at 1290.23.

The Market Volatility Index ($VIX) soared this morning, reaching a new relative high of 56.74, within 0.54 of last September's high, before falling to 45.29 on the rally. Only three times previously has the volatility index reached over 50: October 1997, October 1998, and September 2001. In the past, extreme reading from the VIX, which reflect the volatility level of the options on the S&P 100, have foreshadowed a rally in the market.

Chart of The Market Volatility Index

The Gold and Silver index ($XAU.X) even got a reprieve, after being beaten up badly this week. The index had fallen from a 71.29 close on Friday, all the way to this morning's low of 56.05, before staging a convincing rally to close at 62.96, up 3.72 on the day.

The day started out with images of the Rigas family being led off in handcuffs, after looting Adelphia Communications for hundreds of millions of dollars. Company founder John Rigas, his two sons Timothy and Michael, and two other executives are accused of schemes which provided them funds to purchase stock , cover margin calls, and even begin construction on a golf course, all at the expense of company investors.

This was followed by news that the House of Representatives and the Senate have agreed on a corporate reform bill. This bill will establish a new independent oversight board, overseen by the SEC, which has the power to investigate and punish accounting firms that audit publicly traded companies. The new laws also focus on separation of stock analysts from investment banking services within the same firm. Tougher criminal penalties, as well as extending the timeframe investors have to file lawsuits are also part of the reforms, along with additional protection for corporate whistleblowers. In a provision aimed at executives who sell stock before a company bottoms out, there are also provisions that prevent company insiders from selling stock during a blackout period during which workers cannot make changes to their pension plans.

Amazon.com, which released earnings after the bell yesterday, posted a narrower than expected loss. The stock, however, was hammered early, opening down more $2.18, before riding the rally up to close within $0.45 of yesterday's close. More interesting, however, is their announcement that they will begin expensing employee stock options as part of their accounting. Many companies used stock options as an alternative to higher salaries during the boom-boom late 90s, which were not counted against the bottom line. This practice, which has received much attention the last few months in the wake of exposure of "creative accounting" procedures at many companies, is surely to take a chunk out of the bottom line.

TIAA-CREF, pension fund administrator and one of the nation's largest institutional investors, came out with the announcement that they are sending requests to 1754 companies, asking that they now expense these options when reporting earnings. This practice could significantly reduce earnings numbers in the future for many companies, depending on how many are currently excluding this cost.

Merrill Lynch announced that they will now include GAAP (generally accepted accounting principles) numbers in their research reports on companies. This could significantly alter the financial appearance for many corporations, who have been reporting pro-forma numbers. GAAP includes one-time charges, while pro-forma does not. If a company is forced to write down the value of a purchase, settle a lawsuit, or restructure, these expenses are not currently reported under pro-forma guidelines. The flip side to this is that one-time profits, such as selling off a unit, are also included.

The Nasdaq announced today that they are awaiting approval of a new exchange, which will list futures on individual stocks. It has been rumored for some time, and now appears to be close to reality, with Nasdaq/LIFFE rep Tom Ascher stating that if approved, the new exchange would open sometime this fall. What does this mean to the options business? Calls and puts are currently priced in relation to one another according to a finite formula, which takes into account the interest cost of carrying a long stock position, and the dividends that the stock pays. The ability to hedge option positions with futures, which have none of these characteristics, could drastically alter option pricing on equities. It will also provide a third leg in the option- stock arbitrage formula, as stock futures will fluctuate around the current value of a stock based on what the belief is about the direction the stock is headed. This can be seen currently in the way the S&P futures operate independently of the 500 stocks on which they are based, although they must eventually come into line as arbitrageurs take advantage of discrepancies. These futures will also carry a 20% margin requirement, as opposed to the current 50% margin requirement for equities, which will allow more investors to trade them. Another important aspect of these futures is the ability to sell short. The uptick rule, which prevents short sellers from selling on downticks, was put in place to prevent markets from getting hammered by those already short an issue. These single-stock futures will allow this type of activity. This will also allow certain types of option positions, which require the shorting of stock by market makers as a risk hedge, to be initiated more safely. Liquidity may improve in equity option markets, as orders for these types of trades now remain unfilled until there is a stock uptick.

After the bell, the big news was AOL/Time Warner, which released earnings and a little bit of news as well. The company reported earnings of 24 cents a share, which beat analyst's expectations of 22 cents. Revenue was also higher that expected. CEO Richard Parsons said, however, that while subscriber revenue was up 20%, on-line advertising revenue was down 42%. Parsons also said that he sees no evidence of an on-line advertising rebound . The big news, however, is that AOL is the target of a federal accounting probe, looking into unusual accounting practices, originally revealed by the Washington Post. CFO Wayne Pace stated that the company's results were audited and signed off on by Ernst and Young. Ernst can't be too happy about the probe after seeing what happened to Arthur Andersen. AOL, which closed at $11.40, was trading down at $10.65 after hours.

Tomorrow should be quite a test to see whether the rally holds. Some pull back can be expected, however if it is small, the bulls may be back in business. As we warned in last night's market sentiment, a continued rally does not necessarily mean the end of the bear market. It could however, provide some terrific trading opportunities.

Steve Price

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