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Tumbling Down the Stairs

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09-23-2002                High    Low     Volume Advance/Decl
DJIA     7872.15 - 113.87 7984.77 7788.42  1592 mln   330/1250
NASDAQ   1184.93 -  36.16 1209.72 1177.41  1432 mln   228/1195
S&P 100   417.38 -  6.52  423.90  412.92   totals     558/2445
S&P 500   833.70 - 11.69  845.39  825.76
RUS 2000  358.68 -  8.60  367.28  356.73
DJ TRANS 2134.53 - 49.49 2185.12  2126.45
VIX        44.71 +  0.16   46.46  43.93
VIXN       59.85 +  0.77   61.46  57.65
Put/Call Ratio 0.88

Tumbling Down the Stairs
by Steven Price

We're bound to get good news from the market at some point, but faith in the most likely source seems to be fading. The Federal Open Market Committee (FOMC), led by Chairman Alan Greenspan, meets on Tuesday. It is at these meetings that interest rate decisions are generally made. The Dow tanked today, ahead of that meeting, indicating that investors are not confident in the possibility of a rate cut.

Without the indication of a rate cut, investors were left to digest this morning's economic data, which brought more bad news. The index of leading economic indicators dropped 0.2% in August. This followed a 0.1% drop in July and exceeded analysts' expectations of a 0.1% drop. This is the third month in a row that the leading index has declined. Industrial production declined for the first time this year and the Coincident Index indicates a weak economic recovery. Seven of the ten indicators were negative. These negative indicators, from the largest negative contributor to the smallest, were interest rate spread, average weekly initial claims for unemployment insurance, vendor performance, manufacturers' new orders for non-defense capital goods, building permits, manufacturers' new orders for consumer goods and materials, and index of consumer expectations. The positive indicators, in the same order, were real money supply, average weekly manufacturing hours, and stock prices. Given the fact that the stock market has given back 80% of its gains from July 24 through August 22, we can discount the last positive indicator. The economy is still growing, but the Conference Board, which tracks the indicators, said that there is a heightened risk of a slowdown. A separate report also indicated that help-wanted ads were down in July for the third straight month.

It certainly looks as though we will be re-testing the July lows in the Dow. A look at the intraday charts for the last few days shows resistance being put in place at successively lower levels each day. Today's rebound attempt was stopped and turned back at 7900, after 8000 served the same purpose on Friday.

Chart of the Dow

The Nasdaq traded below the July low of 1192 today, closing at 1184.93, establishing a new 6 year low. Going back to July 1996, 1000 seems to be the next likely downside target. The level was tested several times as the Nasdaq began its ascent to 5132.52 in March of 2000. However, we have not yet seen this level tested in a downward trending market. A level that once proved resilient as companies grew, may not be so resilient as business contracts.

Chart of the Nasdaq

If nothing else, the recent drop has reaffirmed the bearish nature of a head and shoulders neckline break, which occurred in all of the major indices. A look at the Dow and Nasdaq breakdowns shows the acceleration downward after the break. We can also attempt to estimate the potential for the current drop by using the distance from the neckline to the top of the head, and projecting downward for the measuring objective of the drop. This objective is used as an eventual target, rather than a prediction that the current down move will head straight for these levels without any sort of bounce. Because necklines can be drawn from different points, the targets are subject to individual interpretation, but these are the targets I see from the graphs below. The Dow shows a downward objective just below 7200, while the Nasdaq has an objective just under 1050, which coincides closely with the 1000 support level identified above.

Chart of Head and Shoulders in the Dow (INDU) and Nasdaq Composite (COMPX)

While we may see some bounce in the markets, we keep receiving negative news across several sectors. This morning, Wal-Mart once again guided toward the low end of its growth range for the month. Target also announced same store sales were below expectations for last week, and were running below plan for the month-to-date. Wal-Mart came in below expectations the last two months, following similar predictions. Wal-Mart typically predicts 4%-6% growth, and has warned that sales would be at the low end of the range, after saying just last week that sales were on track. Federated, which owns Bloomingdale's and Macy's, said that same store sales would be "at best" toward the low end of its 3%-5% increase guidance. This may be foreshadowing another downturn in consumer spending. Wal-Mart is generally considered a good measure, since it carries products across a wide range of categories and provides a low cost alternative. The fact that both Wal-Mart, at the low end of the pricing scale, and Federated, toward the upper end, are both lowering forecasts, seems to indicate consumers at all levels are cutting back.

Further evidence of this reduced spending came from Maytag, which after the bell warned that third-quarter earnings would fall shy of expectations. This is partially attributed to sluggish sales of appliances and lower production rates. Office furniture maker Steelcase (SCS) also missed expectations by 0.02 per share.

Money continues to flow out of mutual funds. Investors withdrew $5.8 billion in the month of August, following a record drain of $53 billion in July. While this may seem like an improvement, it was the first time in 14 years that stock funds saw money flow out in a month in which the stock market was up. This lack of investor confidence shows that any rebound will be fighting an uphill battle. In what looks like a vicious cycle, if investors are pulling money out of mutual funds when the market goes up, then one of the biggest sources of buying power is losing strength, even when other sources are getting back in.

The tech sector saw more downgrades this morning. Deutsche Bank and Bank of America issued bearish commentary, highlighting the weak demand for computer production equipment and manufacturing services needed to build the latest high-tech products. Credit Suisse First Boston cut its estimates for several chip equipment makers, including Applied materials (AMT), KLA-Tencor (KLAC) and Novellus (NVLS). Barrington Research reported that equipment orders have been weakening after seeing seven months of previous upturn. Orders fell 5% from July to August. Soundview Technology Group also lowered estimates on several techs, including Dell (DELL), Gateway (GTW), Apple (AAPL) and Hewlett Packard (HPQ). In addition to these downgrades, JDS Uniphase also lowered its quarterly sales forecast by as much as 9%, due to contract cancellations. All of this news combined to send the Semiconductor Sector to not only new 52-week lows, but also a new 4-year low of 236.19. The index has now lost 35% of its value in the last month, since it traded up to 363.03 on August 20, during last month's rally. After the bell, Palm beat earnings estimates by a penny, but missed revenue targets, and lowered revenue expectations for next quarter.

Apparently the financial community is beginning to feel the heat, as a report in the Wall Street Journal indicated that Lehman Brothers would be laying off 10% of its staff. Goldman Sachs may be laying off 10-15% of its investment banking staff, as well, according to the New York Post. With fewer mergers and acquisitions, and a virtual halt in IPOs, many of these investment bankers simply aren't needed anymore.

As reports have surfaced that Iraq will not be giving unconditional access to weapons inspectors and will not accept any new revisions to the 1999 U.N. resolution. U.N. Secretary- General Kofi Annan said that inspectors from the U.N. Monitoring, Verification and Inspections Commission would be bound by a new resolution and so should Iraq. It sounds like Saddam is already playing games with the new inspections and the oil futures seem to agree. December Crude Oil Futures (CL02Z) broke above $30 a barrel today, to close at $30.50.

The fuel pinch appears to be making its way to the airline industry. The major airlines are seeking additional help from Congress, to help with the increased cost of security and insurance, as well as to deal with higher fuel costs. There have been analyst warnings that this year's losses could exceed last year's, which amounted to a staggering $7.7 billion. According to Delta Chief Executive Leo Mullin, "Revenue is not coming back... It's not a pretty picture."

On the positive side, Black and Decker (BDK) came out and reaffirmed earnings guidance and Tenet Healthcare (THC) raised its guidance, exceeding previous forecasts by 0.05 per share. One other interesting note that may be foreshadowing a bounce in the near future is the fact that the Market Volatility Index (VIX.X) only increased by 0.16 on a triple-digit down day in the Dow. Volatility generally increases by a larger percentage on drops. This indicates to me that firms may have been selling volatility (option premium) as it tried to increase. This does not usually occur prior to big drops. While it is not a specific indicator, and could simply be due to the end of day rally, it does arouse suspicion. The put/call ratio also decreased from 1.16 to 0.88, demonstrating a return to more calls trading than puts.

I usually try to present both sides of the market, however today it was awfully tough to find a silver lining. The fact that the Dow rebounded strongly from today's low of 7788.42 to close at 7872.15 could be seen as a positive, but this bear is looking harder at the resistance at a lower level of 7900. With the Fed getting together tomorrow, we could see another sell-off if rates are left unchanged, as expected. The bond market has actually done most of the work for the FOMC, with mortgage rates continuing to seek out new lows. With the economy still growing, albeit at a snail's pace, it is unlikely the Fed will use up its few possible remaining rate cuts, unless absolutely necessary. The Fed Funds rate stands at 1.75%, and that does not leave much room for action, if and when it is needed more than now. Expect the rate to remain unchanged, and the easing bias to remain in place, as well. As we approach the July low, we are likely to experience a "dead cat bounce" at some point. However, given the height of the fall, even a dead cat may bounce a few hundred Dow points. I wouldn't be closing short positions just yet, as we still have some room to the downside, but a tight stop on your positions should serve to lock in profits when we finally do bounce. That bounce may simply provide additional short opportunities on a rollover, until we get some good news from the economy. And from the looks of things, it could be a while.

Steve Price

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