Option Investor
Market Wrap

We Know One Thing

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02-10-2003                   High    Low     Volume Advance/Decl
DJIA     7920.11 +  55.88  7933.68 7801.29   1452 mln  942/486
NASDAQ   1296.68 +  14.21  1298.57  1275.19  1186 mln  894/266
S&P 100   422.03 +  3.24   422.91  415.49    totals   1836/752
S&P 500   835.97 +  6.28   837.16  823.53
RUS 2000  362.10 +  3.32   362.10  356.91
DJ TRANS 2144.74 +  4.77   2151.52 2111.75
VIX        37.70 -  1.10    40.48   37.53
VIXN       47.31 -  0.95    49.52   47.22
Put/Call Ratio 0.94

We Know One Thing
By Steve Price

One thing was made clear to us today - anything can happen to the market in a world on the edge of political turmoil. We began the day with the continuation of the downward grind we've witnessed since breaking down below the support level that held us through the end of January and beginning of February. We set yet another relative low and tested the next downside support level, with little more than a dead cat bounce. Things were looking ugly for most of the morning and considering last week's breakdown, the lack of a more significant bounce just fed the bears. Then we got news that Iraq would allow U2 reconnaissance flights. We got a big bounce, taking out several intraday levels of resistance. That reaction simply led us know that we are playing with fire in any position we initiate. Does that mean we shouldn't be trading? Not necessarily. It does mean, however, that traders willing to take on a world of uncertainty should be playing primarily with risk capital.

While it is likely that Iraq is simply trying to postpone the inevitable, just four days before the next UN weapons inspectors' report, it was good enough to bring a knee-jerk reaction from the markets. It was likely a quick round of short-covering by panicky bears, but also could have been bulls playing a longer delay before bullets fly or the possibility that Iraq is going to slowly give in. In any case, it was a red flag for both sides.

While the downside levels we tested this morning do not appear to be strong support from a past snapshot, the fact that we bounced from them is enough to give them some credibility. The morning low on the Dow was 7801, lending credence to the round number support at 7800. The SPX bottomed at 823 and the OEX at 415. The lows in the COMP and NDX were 1275 and 950, serving as quarter increments that we can now use as focal points.

How do we determine just how much of the action we are seeing is due to political concerns and how much is simply due to the strength or weakness of equities? It is impossible to answer that question decisively, but we can begin to look at some signals that tell us where we can expect a change in sentiment if we will get it at all. While we can blame today's bounce on the news, it did come at a curious time, with several other indications that we were reaching support/resistance that could have signaled a turn.

First, let's take a look at the bond market. Yields signal the inverse of bond activity. As bonds are sold, yields rise, and can be used to track action in the equities as funds flow between the two markets. A look at today's action in the ten-year yield shows that the yield actually began to find support and turn higher prior to the announcement from Iraq. We approached Friday's low, but did not break it, even as the major equity indices were finding new lows. That was our first signal that the drop had slowed on its own and the flow of money from equities into treasuries was drying up. At that point bears could have begun to protect short positions, even without having any idea what was about to hit the newswires.

Chart of the 10-year Yield

Chart of the Dow

The other indicator that began to signal oversold conditions and was bumping up against both horizontal resistance, as well as a descending trend line, was the Market Volatility Index (VIX). The VIX measures option premium levels in the OEX and can bee seen as an indicator of downside fear, along with the put/call ratio. As the markets fall, the VIX generally increases, as traders become wearier of selling options and covered stock writers sell stock and buy in short options. It generally reaches support and resistance levels at similar times as the equity markets, although in an inverse manner. This morning, as the Dow was testing support at 7800, the VIX was once again testing resistance at 40%. I say once again, because that 40% level has acted as resistance for the last three sessions, as well as on the January 27 drop. Bulls will call this a contra- indicator, telling us when to expect a bounce. However, while we have bounced intraday in conjunction with tests of that resistance level, we have also continued the slow downward slide in the equity markets on subsequent days. That tells me that it can be used as an indication of when we may bounce, but it doesn't necessarily mean the bounce will hold. That being said, the 40% level also signaled a longer term rally in the equities as it fell away from 40, on its way down from the 50s, in late October. In fact, that drop from 40% was a good indication that we'd be headed higher for a while, as the market continued higher through early December. We are testing it from the opposite direction this time, so the circumstances are different, but it still serves as a pivotal level to keep our eyes on. If we continue to fail to breakthrough that level, we may be looking at a bounce in the broader markets. If we breakthrough decisively, we may be in for another leg down in the equities and another trip into the 50% range in the VIX.

Chart of the VIX

A couple of other political indicators also showed a belief that the move by Iraq may at the very least stave off the formation of a coalition against it in favor of an invasion. Gold futures continued the sharp reversal from last week's highs ahead of Colin Powell's U.N. presentation. After reaching a high of 388.9, gold futures have sunk down to a low of 363.7 over the past three sessions. Gold is seen as a defensive play that has closely mirrored the action on the geo-political front and can be monitored for signals of just how much fear is built into the stock market as an additional measure of where investors are putting their money. The higher the degree of fear of war, the more money seems to come out of stocks and into gold.

Chart of Gold Futures

The other indicator of war fears is oil. While the general strike in Venezuela has also played a part in recent swings, oil has moved in concert with gold as geo-political events develop. Oil headed lower today, following the action in the gold market, after the Iraqi announcement. It still remains elevated, with the futures trading over $34 per barrel. On Friday, we cracked the $35 per barrel mark and although we have pulled back, the possibility of war is anything but discounted. The pullback more likely forecasts a delay in the war and thus prices remaining lower for a longer period of time.

Chart of Oil

Today's bounce was nice, but fell short of a reversal on the point and figure charts that gave us triple (and quad in the case of the Dow and SPX) bottom sell signals last week. Those sell signals were confirmed with additional boxes of "O" in the current column that got us past the technical bear trap. Of course, with political event risk, we have to look at technical indicators with a skewed eye, but they still do a good job of measuring the strength of investors' reactions to the news. After all, regardless of the news, we are most concerned with just how committed traders really are from the bearish or bullish side and technical indicators give us a great picture of that commitment. We can come up with any number of scenarios as to just how the market will react to war. Many pundits are saying to go long when the bullets start flying, because that's what you should have done in 1991. But if the cost of oil skyrockets, won't that be a huge negative for the economy in the short term? What if history does not repeat itself? Remember, in 1991, the market traded at much lower values and the tech revolution had yet to emerge. We were looking at a much different picture, so whose to say that we will see history repeat? If we do achieve point and figure reversals into columns of "X", remember the last four have each led to selling opportunities. Of course, the reversals down, prior to the triple-bottom sell signals, were buying opportunities over the last month and that has not been the case over the past few days. However, that should only serve to underscore the overall bearishness of the market.

Another bearish sign came out of the tech sector. The Nasdaq Composite had been holding steady just above the 1300 support level up until last Friday. While the broader indices were setting new relative lows, it was clinging to support at that round number. It had been significant support in the past and the drop through that level seemed to signal that the last domino had fallen. This morning's activity before the announcement seemed to confirm that theory, as we continued to set new relative lows. However, the news led to a rally in almost all equity sectors, including the techs. The COMP, however, topped out at 1298, just below the level that had served as strong support. The general rule is that support, once broken, tends to act as resistance. That certainly appears to be the case here. If bears can take anything from the rally, it seems to be that they can now rely on that resistance slowing any intermediate rallies.

So what can we take from today's action that will help us tomorrow or the next day? First of all, we saw that sentiment was still down to open the session. Second, we saw the power of political developments on the market, with a sudden 100-point swing to the upside in the Dow as soon as the news hit the wires that Iraq would be allowing U2 fly-overs. However, before we saw those developments, we saw signals from the VIX and the bond market that a turnaround may be in the cards ahead of time. We also saw confirmation of the politically motivated rally from the oil and gold markets. Essentially, on a day when we saw few technical indicators change by much, we got snapshots from a number of different areas that traders can use to predict future movement and rely on for explanations of why they saw what they saw.


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