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The Floor Drops Out

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10-07-2002                High    Low     Volume Advance/Decl
DJIA     7422.84 - 105.56 7637.91 7404.94  1787 mln   303/1460
NASDAQ   1119.40 -  20.50 1145.79 1113.36  1406 mln   385/1008
S&P 100   396.15 -   7.07  408.26  394.80   totals    688/2468
S&P 500   785.28 -  15.30  808.21  782.96
RUS 2000  338.29 -   9.69  347.98  337.57
DJ TRANS 2058.57 -  79.11 2139.48  2050.92
VIX        49.18 +   2.90   49.71  46.28
VIXN       62.32 +   2.04   62.48  59.69
Put/Call Ratio 1.04

The Floor Drops Out
By Steven Price

I have always tried to trade what I see, rather than what I feel. I kept seeing repeated support at the 7500 level in the Dow, the 800 level in the S&P 500 (SPX.X) and the 400 level in the S&P 100 (OEX.X). However, the market has "felt" bearish. Now that we have broken these levels and closed below them, what seemed an appropriate level for a bounce has wilted. There are still some intraday lows below us in the SPX and OEX, that could provide some support, but that is looking less likely now that we have closed below the aforementioned levels. In the Dow, we are below July levels and must look back to 1998 for support at the 7400 level and then the 7000 level back in 1997. The breakdown below these levels is significant, but what could be even more significant is whether we now find resistance here. Look for intraday resistance for evidence of another leg down.

Chart of The SPX (S&P 500) and OEX (S&P 100)

Chart of the Dow

The S&P Banks Index (BIX.X) once again sought out new lows today. The Kbw Bank Index (BKX.X) has not yet crossed its July low, but is heading in that direction. We have now reached a crucial level in support for the group that can be seen in the weekly chart below. If support at this level of 235 in the BIX is broken, expect another quick drop to around 210. The Wall Street Journal reported that J.P. Morgan (JPM) is getting ready to cut more jobs. Last month, JPM announced that its earnings would be significantly lower than expectations, partially as a result of trading losses and bad loans to the telecom sector. Now the speculation is that it will be cutting jobs from the mergers and acquisitions, private banking and underwriting departments, and is mulling about 4,000 job cuts. The company releases earnings on October 16, which would be the most likely time for the official announcement. Similar reports have circulated about Merrill Lynch, which has already cut about 15,000 jobs this year, and Credit Suisse First Boston and Goldman Sachs. Investment banking activity has shrunk considerably, with very few mergers and IPOs taking a chance in the current market environment. In the late nineties, these banks expanded rapidly in those departments to keep up with demand at that time and are now severely overstaffed. What is equally as troubling is the pattern that followed JPM's announcement about non-performing debt. Last week, Comerica (CMA), Bank of New York (BK), and Northern Trust (NTRS) also issued warnings related to bad loans. It will very difficult to get a significant rebound in the broader markets if the banks are just now starting to release details of how the recent economic downturn has caught up to their bottom line. While BK identified the telecoms as a source of bad loans, as well, Comerica cited loans to the retail, automotive and manufacturing sector. Comerica and Northern Trust, which are regional banks, showed us that it is not just the big banks having problems. Goldman Sachs downgraded several specialty finance stocks, due to a lower intermediate term outlook on credit, housing and growth. Those stocks include Americredit (ACF), which concentrates on auto financing, Capital One (COF), which focuses on credit card lending and Household International (HI), which has both consumer and credit card divisions.

Daily Chart of the S&P Bank Index

Weekly Chart of the S&P Bank Index

The retail sector seems to be picking up steam to the downside as we approach the holiday season. Holiday sales account for a large percentage of the year's profits for most retailers and the summer and fall sales warnings are bringing ominous projections for the winter. Over the summer, retailing giants such as Wal- Mart (WMT) and Federated (FD), which owns Bloomingdale's and Macy's, repeatedly missed same-store sales numbers. We either got sales at the low end of projections, or complete misses as the summer turned to fall. The slowdown was repeatedly blamed on warm weather keeping shoppers outside, rather than in stores, and the lack of need for cool weather clothing. The slowdown was followed by warnings last week from Aeropostale (ARO), citing a lack of customers in shopping malls, and Wet Seal (WTSLA), both teen-oriented clothing stores. Today, Sears (S) warned that problems with its credit division would lower third quarter and full year results. They tried to spin this by saying that strength on the retail side helped offset issues at its financial services division, however, if customers can't pay for the goods they purchased, I'm not sure how strong that retail side can really be. In light of other retailer's warnings, it is also hard to imagine how only Sears is doing well. Investors didn't buy that line, either, as they sold off retail stocks across the board. As we head toward the holidays, the West Coast dock lockout is starting to have a more pronounced effect, as well. While the White House has decided to get involved in the dispute, there are a couple of issues that are hurting retailers. First, simply the lack of goods that can be put on shelves leads to lower sales. But there is also the issue of higher alternative transportation costs, as full overseas charter flight fees have increased by $100,000.00 per trip in some cases. Current higher fuel costs don't help the cost of air transport, either. In addition to those costs, there will now be a delay in getting these ships back overseas to pick up more goods to be delivered closer to the holiday season, which will extend the effect for several months after any settlement. The Retail Index (RLX.X) has now broken below its July closing low and shows little sign of slowing down. There will likely be a boost to the sector when the lockout is settled, but the damage has been done.

The lockdown is also leading to layoffs for workers used to ship and stock goods, and hitting U.S. agriculture, which relies on the ports to export food products.

Another sector that has led the current slide is the semiconductor group, which reflects overall tech demand. It seems almost redundant to talk about more downgrades to this group, but that is what happened again today, as Prudential cut estimates on several chip stocks. Prudential downgraded its Communications Semiconductor rating to Market Underperform from Market Outperform. Individual stocks that saw cuts were Broadcom (BRCM), Cypress Semiconductor (CY), LSI Logic (LSI), Emcore (EMKR) and Microtune (TUNE). The Semiconductor Sector Index (SOX.X) sought out yet another 4-year low and looks like it is headed to 200 before finding any real level of technical support. In fact, Merrill Lynch was left holding the bag and may become an involuntary owner of up to 18% Chartered Semiconductor Manufacturing (CHRT), as it was the lead underwriter of a $633 million rights issue that was vastly under subscribed. The software industry got a mixed message, as well. While Oracle (ORCL) said it expects a recovery in 2003, it also said that it did not expect things to get better in the short-term. This sounds like pretty much the same rhetoric we have been hearing since the market started dropping in 2000.

Chart of the SOX

American Airlines' parent AMR Corp (AMR) said it will take a $990 million charge to write down the carrier's entire goodwill balance. This basically measures the amount AMR overpaid in the acquisitions of AirCal, Reno Air, AMR Eagle and TWA.

On the positive side, Cambridge Consumer Credit reported that Americans are spending less on their credit cards. The index, which dropped 3 points in September to 53, surveys consumers to find out if they have increased or paid off debt in the last month, what they plan on doing with their debt in the next month, and in the next six months. The reality gap, which measures the difference between what consumers said they would pay off and what they actually did, dropped 3 points as well. A Federal Reserve report also indicated a slowdown in consumer credit.

The Market Volatility Index (VIX) is once again approaching the 50 level, closing today at 49.18. The last 3 times we have hit 50 in the VIX, market rallies have followed. While these rallies followed volatility spikes, it is certainly worth noting that a VIX over 50 has been the precursor to temporary bottoms. Of course, it has usually stretched a bit over the 50 level before that rally has taken place. See the charts below for a comparison of the VIX and the Dow.

Charts of the Market Volatility Index (VIX.X) and the Dow

All signs are certainly bearish and I would be extremely careful with long positions. Now that we have broken the July lows and support levels, it seems that we will most likely re-test 7000 in the Dow. The previous downside-measuring objective discussed in this column based on the head and shoulders break was right around 7100, and I would look for a slowdown at that level. That would probably put the VIX in the high 50s again as well, the point at which the market previously bounced. With President Bush's speech about Iraq tonight, we should get a good look at just how the markets will react to his plan. If the war rhetoric heats up, we will most likely head down in the morning. I'm pretty sure he will make some positive remarks about the economy and defend the impact a war would have on us. However, if form holds, tough talk from the President should send us down tomorrow.

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