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Allocate This

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08-14-2002               High    Low     Volume Advance/Decl
DJIA     8743.31 +260.92 8748.29  8353.07 1722 mln  2017/730
NASDAQ   1334.30 + 61.22 1334.31  1265.19 1053 mln  2193/1065
S&P 100   464.44 + 19.14  465.05  441.42   totals   4210/1795
S&P 500   919.62 + 35.41  920.21  876.20
RUS 2000  389.41 + 11.65  389.41  374.03
DJ TRANS 2306.12 + 41.89 2309.25  2212.39
VIX        40.46 + 1.10    42.90  39.98
VIXN       56.29 - 2.41    59.13  56.09 
Put/Call Ratio 0.82

Allocate This
by Steven Price

D-Day has arrived for the remainder of the 695 companies that must certify their financial results by today at 5:30 p.m. We have been inundated with reports of who has reported so far. The SEC has stated that it will be at least a week before they can tell for sure who has fully complied with the deadline and who has not. We expected a few revelations and were not disappointed.

Household International (HI), which certified results today, also announced it was restating earnings since 1994. Earnings were revised downward by a total of $386 million, including 2002 earnings, which will be lowered by 0.01 for the 2nd quarter and 0.06 for the first half of the year. HI blamed this restatement on collapsing accounting firm Arthur Andersen, stating that new accounting partner KPMG determined that the company should have been expensing certain costs over several months to a year, rather than amortizing them over several years.

Nicor (GAS) said they will restate first quarter 2002 financial results, and that its CEO and CFO could not certify its 2002 interim financial results due to uncertainties pertaining to its gas distribution unit's results. Apparently the SEC is looking into improprieties at the company's gas supply program and accounting at a joint venture between Nicor and Dynegy.

Dynegy (DYN) also announced that its officers will not be able to certify results, due to a pending restatement of its 2001 financial results and a 3-year re-audit of its books.

AOL certified its results, but included a caveat. It said it is re-examining 3 deals conducted over 6 quarters by its America Online Internet Unit. The deals may have been improperly assessed as advertising and commerce revenue. The total of all three deals amounts to $49 million. The company said it discovered the possible violations within the last 10 days. This sounds about as believable as Worldcom's recent "discovery" of an additional $3.3 billion in overstated earnings. It is amazing how a deadline can jog the memory, especially when it involves prison time.

Applied Materials (AMAT) issued a negative outlook after yesterday's bell, predicting a 5-15% decline in orders for the current quarter. The company was downgraded by UBS Warburg, which cut estimates to below the company's own guidance. In spite of the bad news, AMAT finished up 0.96 on the day.

I find it interesting that with today's action, which involved a 395-point swing in the Dow, the VIX dropped well below 40. The Dow bottomed out at 8353.07 this morning, before staging a comeback to finish at 8743.31, after reaching a high of 8748.29. On most up-days this pattern would seem normal, and with the Dow up 260.92 , one would expect to see a drop in the VIX. Today, however, has shown a struggle between the bears and bulls, with the two tug of war teams pulling the center flag to the brink of victory, only to see it pulled back the other way. The final surge did not result from fundamental news about the economy, or positive news from any particular bell-weather stock. Apparently, investors have been lulled into a false sense of security by all of the CEO and CFO filings. I don't see how a CEO stating that his company's accounting statements are accurate can leave an investor bullish. These leaders are already supposed to stand behind their companies' reports. Signing off on the numbers does little to change an economic environment even the Federal Reserve sees as risky.

On the other hand, companies that do not comply certainly will be raising gigantic red flags. The SEC does not have specific penalties in place for a CEO who does not certify, but a false certification can lead to a $5 million fine and up to 20 years in prison. Therefore, a CEO who has some doubts, has nothing to lose in terms of personal penalties from a delay, but an awful lot to lose by signing on the dotted line. Bulls may see these delinquent filers as cautious; bears will pile on without mercy.

This may be part of the explanation for today's rally, as the certification reports flowed in. The other explanation may be asset-allocation programs, which were triggered as bonds reached new lows. The bottoming in the 5-year yield, and 10-year yield appear to have triggered a switch from low yielding bonds into stocks. A look at the 5-minute charts of the 5-year and 10-year Treasury Notes shows allocation kicking in at 10:15, 12:00, and 1:30. Note that the yield drops with an increase in bond price, so a selling of bonds creates an increase in the yield, resulting from a lower bond price. The graph below represents the yield.

Chart of the 5 year Treasury Note

Chart of the 10-year Treasury Note

A look at the Dow Industrials shows the index finding a bottom at each of these allocation points, and experiencing a rebound. The simultaneous time at which these trades occurred, in all three markets, lends credence to the theory that the primary reason for today's rally was that asset allocation programs pulled money out of bonds and into stocks.

Chart of The Dow

A look at the Point and Figure charts of the Dow and S&P 500 shows today's rally creating something we haven't seen in a while. The S&P chart established a new buy signal using a 10- point box. The Dow, on the other hand, continued its downward sell signal. A closer look, however, shows that the Dow is actually a mere 56.69 points away from also creating a new buy signal on a triple top breakout, using a 50-point box. Concurrent buy signals on both charts may be enough to convince some bears to come out of hibernation and strap on the horns.

Chart of the S&P 500 Point and Figure

Chart of Dow Point and Figure

The stars seem to be aligning for a break to the upside, yet the fundamentals have seen no real change. If the Federal Reserve still sees danger to the economy, then is jumping in long the right move at this point? With September 11th looming, it would seem hasty at this point to jump on the train. After all, how many investors will want to hold long positions heading into this date, knowing there is a possibility of an anniversary attack. Even in the absence of such an event, the fear alone may cause a severe anticipatory drop.

The airline industry is certainly showing signs of continued failure one year later. United Airlines (UAL) today confirmed that they are preparing for a possible bankruptcy filing this fall. They are still hoping for a $1.8 billion federal loan guarantee. Chief Executive Jack Creighton stated , "The changes we need to make are urgent, significant and immediate... Simultaneously, we are preparing for the potential of a Chapter 11 bankruptcy filing this fall, due to our fourth-quarter debt payments. Unless we lower our costs dramatically, filing for bankruptcy protection will be the only way we can ensure the company's future and the continued operation of our airline." The NYSE has also permanently suspended trading in shares of U.S. Airways, which filed for bankruptcy on Sunday.

After the bell, Brocade reported earnings that met expectations and also added that the third quarter showed double-digit gains from a year ago in sales and profits. Net income was up 31% from the previous quarter and 52% from last year. Total revenue of $151 million beat estimates by $3 million. Sales were up 12% from last quarter and 30% from last year. The stock was last trading $16.34 after hours, following a close of $15.05.

ImClone also announced earnings, losing 0.59 versus expectations of a loss of 0.41. The company blamed the loss on increased research costs. ImClone also announced it was suing former CEO Sam Waksal for return of his $7 million severance package.

With the summer earnings season just about completed, 468 of the S&P 500 companies have reported. 61% of these companies have beat estimates, 24% have matched and 15% have missed forecasts. This would seem bullish, although most of these earnings estimates had been previously lowered so much that a snake could crawl over them. Tomorrow we will get a look at results from NVidia and Dell.

After what has been a wild ride the last few days, look for 8800 as the next significant level in the Dow, as this would confirm the S&P 500 buy signal noted above. A trip back over 1000 would look bullish for the Nasdaq, as well. I still see a lack of fundamental strength, compounded by the September 11 anniversary around the corner. The Fed's easing bias may be sinking in and the market may be taking off on new euphoria over a possible surprise rate cut between now and the September 24th FOMC meeting. My guess is that it will not come until after September 11th. If the market continues to rise, it may not come at all. A trend is a trend and fighting it only leads to lost opportunity. A breakout above 8800 may convince this skeptic to go along for the ride.

Steve Price

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