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Conflicting Signals

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10-02-2002                High    Low     Volume Advance/Decl
DJIA     7755.61 - 183.18 7969.37 7742.02  1912 mln   362/1513
NASDAQ   1187.30 -  26.42 1222.72 1183.76  1741 mln   456/1269
S&P 100   415.93 -   9.81  428.37  414.96   totals    818/2782
S&P 500   827.91 -  20.00  851.93  826.50
RUS 2000  360.22 -   7.87  369.68  360.18
DJ TRANS 2135.21 -  89.97 2225.71  2131.64
VIX        43.36 +   3.23   43.78  40.10
VIXN       58.15 +   0.91   59.45  56.35
Put/Call Ratio 0.83

Conflicting Signals
by Steven Price

We're starting to see the first conflicting signals in some time. In fact, since August 22, when the end of summer rally ran out of steam at 9077, the signals have been pretty clear that we would be re-testing the July lows. If they weren't evident immediately on the rollover from that level, they were at least consistent on the way down. The first real sign came on September 3, when the Dow dropped 355 points. While a big drop can signal a change in sentiment, the size of the drop was not as significant as the level it reached. It marked the first lower low since the rally from a low of 7532 on the morning of July 24 took the Dow back over 9000 by the end of August. The Dow then found support and rallied up to September 11. The significance of the September 11 high is that is was a lower high, following the lower low. This was followed by a textbook head and shoulders pattern, with a neckline break at 8300 that signaled the continued drop. As of right now we have still not seen a higher high in the Dow or Nasdaq. However, we have come awfully close and certain levels that now bear watching.

In the Dow, I am watching the intraday high of 8012.42 on 9/26, and the closing level of 7997.12. Today's rally fell short of both of these levels, with an intraday high of 7969.37 and close of 7755.61. However, now that we have tested the July low and rebounded, we need to watch for signs of a true bottom, or a false one. A break above these levels, and a close above the psychological 8000 barrier, could be the first sign of a turnaround. This may be premature, since we actually found a lower low than we did in July, but there has been an awful lot of activity between 7500 and 8000 and there are plenty of signs to watch for. After today's warnings after the bell, we may be closer to re-testing the low by the end of the day Thursday, after failing at the high the last couple of days. Something to keep in mind when looking at technical levels of these indices is that they are made up of many stocks, so minor breaks in support and resistance levels should not be viewed as exactly as those in an individual stock, which requires and attracts more focused buyers and sellers.

Chart of the Dow

In the Nasdaq, we are closer to the center of the high/low range, but given the large swings in the index recently, we could test these levels on any day soon.

Chart of the Nasdaq

Dell's announcement after the bell on Tuesday, that it was raising revenue forecasts and earnings guidance, indicated that we would be seeing a follow through rally this morning. That follow through did not materialize, and we were unable to set a higher high. However, the Semiconductor Sector Index (SOX.X), which tracks companies with a heavy interest in Dell's business, did hit a higher intraday high today. It also looks to be forming higher lows, although just barely. That intraday level did not hold up and by the end of the day, the closing price, in contrast, did not reach a higher high. So how much stock do we put in the intraday high? What it does is throw up a red flag. While I look at closing prices as a more significant measure, since they represent what traders are willing to take home overnight, the fact that the intraday range gave a signal tells me that a level where sellers were previously strong does not show the same strength as it once did. The same is true for support, where buyers are not as committed as they once were, when we see a lower intraday low. Now that we have seen a higher intraday high, I will be more cautious with shorts in the sector.

Chart of the SOX

After the bell, Advanced Micro Devices (AMD) warned of a substantial operating loss and revenues far below expectations for the third quarter. The company said it would lose $0.49 per share and see revenues of $500 million, down from expectations of $614 million. The company said that it had cut inventories of its processors for the PC market, due to persistent weak PC demand. This takes some of the shine off of the Dell announcement and may make the intraday high a distant memory. However, until we see a break below the low of 231, we are still in a range.

After a massive rally of almost 350 points in the Dow yesterday, some type of pullback could be expected. That makes it hard to tell whether the failure under 8000 is a significant sign of weakness from a failed rally, or a normal pullback. Until we cross one of the levels described above, we may not know which direction we are ultimately headed. That being said, there is still a 500-point range in which to trade, and we know that the trend is still down. There has been talk of a surprise rate cut by the Federal Reserve prior to their next meeting on November 6. That seems to have been the catalyst, along with the Iraq news, for yesterday's rally. However, that news wore off and we gave back about half of yesterday's gain. A warning from Dow Chemical seemed to be the catalyst for today's drop. The company warned that its 3rd quarter earnings would be just over half of previous forecasts. Dow said the decrease was due to higher feedstock costs, which is directly related to higher oil prices. In a downward trending market, we still have to assume bearishness and today's drop was the reminder not to get too excited until we see a decisive break in the opposite direction.

One indication that all was not necessarily well after yesterday's rally, was the Market Volatility Index (VIX.X). In an upward trending market, implied volatility, as measured by the VIX, generally drops. The one exception to this rule was the internet boom, when volatility increased as stocks gapped up $20 a day, and the risk seemed as significant to the upside as the downside. With those days behind us, however, we are back to the old rules. Implied volatility is higher to the downside because stocks generally fall quickly and go up slowly. This can be seen in the implied volatility skew of options on almost any listed equity, with downside strikes holding more relative premium than upside strikes. A 5-year weekly moving average of the VIX shows a reading of 26.75. A reading of 40 is an increase over that average of almost 50%, and is considered very high. The fact that yesterday's 346-point rally in the Dow was not able to push the VIX below 40 indicated continuing fear of a sell-off. The VIX closed at 40.13 on Tuesday, and today ran back up to 43.36. Some traders see this as a trailing indicator and some see it as a contrarian indicator, but I've seen many institutions come into the pits selling premium when they consider it to be too high. The fact that there was not enough individual and institutional pressure to lower these levels is an indication that the institutions are not large sellers of premium at these levels, and are not believers in a big rally on the near horizon. A rally would shrink premiums and earn profits for those sellers. As for the contrarians, they tell us that VIX spikes usually foreshadow a market rally. While this is true in the sense that the VIX spikes heavily on market crashes and then falls on the rebound, a consistently high VIX, which increases in a series of higher highs and higher lows, should not be considered a spike, and therefore not a contrarian indicator. That is what we are seeing now - a series of higher highs and higher lows.

Chart of the Market Volatility Index (VIX.X)

The West Coast port lockdown has continued to get press, as the National Association of Manufacturers appealed to the unions to reopen the ports. The group president said, "An extended shutdown will have a negative and cascading impact on economic growth, rob retailers of product, spoil food, shut down assembly lines, and eventually lead to layoffs." My guess is that the U.S. President will get involved in plenty of time for the holiday shopping season, if an agreement cannot be reached. We keep hearing that it is costing the economy $1 billion a day, but if demand simply becomes pent up during that period, at least the non-perishable goods should be able to make up a significant portion of the losses when the gates re-open.

Additional warnings came after the bell from the Bank of New York (BK) and Guess (GES). The BK warning followed a similar warning at Comerica (CMA) this morning, which echoed the sentiment heard a couple of weeks ago from J.P. Morgan (JPM). Bad business loans are eating into the bank's bottom lines. BK saw problems similar to those of JPM, which stemmed from non-performing loans to the telecom sector. CMA blamed its restatement on problem loans to the retail automotive and manufacturing sectors. The pattern is disturbing, as a second wave of bad news stems from the economic downturn in many industries. These companies have either gone bankrupt or on their way there, and the banks that financed their growth are now taking the hit for a double dose to the market. There are likely many other banks facing the same problems, and if the banking sector tanks as the problems mount, any market recovery could be a long way off.

The Guess warning just reiterates what we have already heard from other retailers: that September sales were terrible, following poor sales over the summer months. Heading into the holiday season, it is becoming apparent that a spending turnaround is not happening, as consumers are worried about jobs, and the layoffs of the last couple of years have caught up to consumer spending.

Ever hit the wrong button on the remote and turn off the T.V. instead of turning up the volume? Well, a Bear Stearns clerk apparently hit the wrong button and almost turned off the S&P this afternoon. At 3:40 p.m., Bear Stearns entered orders to sell $4 billion worth of S&P securities, rather than $4 million worth. They were able to cancel all but $622 million of the orders prior to execution. This would have been an easy excuse for the end of day drop, had it not been 20 minutes before the close. There may be a bounce in the morning in some of those issues that were hit by mistake, however, the overall market direction should only be affected slightly, as the Dow gave up only 25 points in the last 20 minutes of trading.

I would look for continued selling in the morning after the end of day warnings. However, if we approach the recent lows, expect to see a slowdown once again. We have bounced in the same area in the Dow on several occasions, so there are some buyers out there around that level. If those bulls go into hibernation, we may see 7000 fairly soon.

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