Option Investor
Market Wrap

Storm Warnings

HAVING TROUBLE PRINTING?
Printer friendly version
        WE 9-26         WE 9-19         WE 9-12         WE 9-05 
DOW     9313.08 -331.74 9644.82 +173.27 9471.55 - 31.79 + 87.52 
Nasdaq  1792.07 -113.63 1905.70 + 50.67 1855.03 -  3.21 + 47.79 
S&P-100  499.61 - 21.01  520.62 +  8.32  512.30 -  0.19 +  9.13 
S&P-500  996.85 - 39.45 1036.30 + 17.67 1018.63 -  2.76 + 13.38 
W5000   9646.48 -407.5910054.07 +176.76 9877.31 - 29.38 +136.23 
RUT      485.28 - 34.92  520.20 + 11.14  509.06 +  0.19 + 11.45 
TRAN    2663.83 -130.88 2794.71 + 59.11 2735.60 - 11.69 + 64.05 
VIX       22.23 +  3.16   19.07 -  1.18   20.25 +  0.88 -  0.12 
VXN       30.88 +  1.14   29.74 -  2.94   32.68 + 11.98 +  1.18 
TRIN       1.42            1.35            1.11            1.04  
Put/Call   0.98            0.68            0.90            0.72  

Storm Warnings
By Jim Brown
Click here to email Jim

No, not another hurricane but the rumblings on the horizon are growing and the storm clouds are beginning to gather. Investors are putting the shutters on the windows and loading up on extra put insurance as October approaches. Bullish investor sentiment was extremely high last week so it is no surprise there may be a change in climate ahead.

Economically Friday contained another batch of mixed messages for the market with the GDP being revised up once again for the 2Q to +3.3%. The gains came from a stronger inventory build up than previously expected and gains in residential building. While the headline number rose higher than expected there were still some internal problems. Consumer spending remained unchanged at +3.8% and the bounce in the headline number was due mostly to the +6.6% jump in housing. Inventory investment still remained negative as businesses continue to lower risk and question future demand. Corporate after tax profits fell even further to -5.0%. Overall the report was positive but the buy the rumor sell the news crowd started to whine that maybe the Q3 estimates which range from +4.9% to as high as +7.0% could be too high. Duh! It appears the bulls are starting to come off their six month high and the headache of sobriety is starting to appear. Yes, the economy is recovering, yes, earnings are going to be up and the GDP could be over +4.0% but +7.0%? What we they thinking?

We also need to remember that the 2Q contained two months of post war positioning for the coming recovery. You know, the one that did not appear as expected. That GDP was built on the hope that a quick war would take the worry out of the economy and we would rebound to the moon. Also, the 2Q GDP benefited in a +45.8% increase in the defense spending component. This is the largest increase since 1951 and a component that is not likely to be repeated. This sets up the 3Q and 4Q for a disappointment if the economy does not pick up the slack. A bright point in the GDP that could be pointing to the next quarter leader was the jump in capital spending for computers and software of +8.2%.

The only other major report was the Michigan Sentiment final for September and it fell to 87.7 from 89.3. This makes the 3rd month of the last four that the index has declined from the high of 92.1 in post war May. Present conditions and future expectations both fell with the present conditions taking the biggest hit. Lack of jobs continues to be the biggest drag on sentiment followed by high energy prices. Now that the tax rebate checks have passed consumers have nothing to look forward to but winter. We will get the nonfarm payrolls report next Friday and it is expected to show a drop of -25,000 jobs or more.

The shortage of economic reports did not give the market any good news to break it out of its dive. The news at the open from Motorola was that they were going to have to delay the delivery of their new highly featured phones for the holidays. MOT traded down all day along with the chip companies that feed the phones. About 3:PM MOT said that the delay would not impact their broader line and they would be shipping 31 new phones in the 4Q including 12 with cameras and 21 with color screens. This produced a sharp rebound in its stock as shorts got squeezed.

The markets lost ground again on Friday and the Dow would have been much worse had it not been for MMM. Banc of America upgraded MMM from neutral to a buy and the stock gained nearly +2.00 on a bad day. 3M also has a 2:1 stock split that takes place after the close on Monday. Only eight of the Dow components were positive for the day and only MMM gained more than 50 cents.

You can scratch September off your investment calendar. All the new highs and all the gains made in September are now history. Without a miraculous recovery by Tuesday of next week the month will close in the red. The Dow lost -3.5% or -331 points last week. The Nasdaq dropped -6.0%, -113 points. The Wilshire-5000 lost -407 points. Even the transportation index got into the act with a drop of -131 points. The Russell dropped a whopping -35 points or nearly -7%. Sectors that had been leaders got whacked badly. The Biotech sector dropped -8.6%, Semiconductor -6.3% and computers -6.6%. The Dow posted its worst weekly loss in six months, the S&P in 8 months and the Nasdaq saw the worst drop in 17 months. While all those negative numbers sound terrible they have to be taken in context. The Nasdaq was up +52% over just the last six months. Losing -6% is a minor correction. The markets are still above the mid August gains and well above July. That could be good news or bad news depending on your point of view. It means we have a nice cushion but it also means that cushion is likely to get thinner.

The excuses for the correction are appearing from every direction. Earnings worries, profit taking, portfolio adjustment, year end fund selling, etc. I do not think it is any one of those specifically but more likely just a normal calendar correction that we have been expecting for weeks. Nothing to worry about unless you are long. Whenever the market tanks the talking heads on stock TV start grasping for reasons to fill the airwaves and make it appear they know what is going on. Sometimes they get it right. Regardless of the reason for this drop it was expected and it will be over soon. Soon on my calendar could be 1-3 weeks. Our only task now is deciding where to go long.

According to First Call earnings for the 3Q are expected to rise +19% for the S&P. The 4Q is currently pegged at +22% to +26%. This is an amazing rebound on paper but when you look at the same periods last year the comparisons should be easy. Tech earnings for the year are expected to be up +80%. Think about it, +80% from what? Many tech companies lost money last year or barely broke even. Only the big guys like MSFT, CSCO and INTC really piled it on at the bottom of the bear market. The 3Q of last year was the bottom of the bear market and that makes the comparisons easy for Q3-2003 but it does not mean techs are raking in the dough.

The economy must be getting better or companies have simply cut their estimates to the point they have no risk in making them. This time last year there had been over 500 earnings warnings for the quarter. This year there is less than 50% of that number. Companies announcing positive guidance are up +20% in the same period. The only problem facing the markets now is confidence in the numbers. With some analysts literally predicting a GDP over +6% for the 3Q there is a significant amount of hesitation on what to believe.

Funds with large profits are trapped between holding on to see if the fairy tale comes true or taking profits now to preserve their strong gains. Hedge fund managers who get paid out of the profits to the tune of 20%-50% of the gains have got a huge bet riding on the line. If your fund is up +30% to +70% for the year the urge to take profits and lock in bonuses is very strong. This occurs every year at this time so the event is not new. The only difference is that there are huge profits this year instead of the huge losses over the last two years. This makes the urge to lock in now much stronger.

There is also an axiom on Wall Street to Sell Rosh Hashanah (9/27) and buy Yom Kippur (10/06). Whether that is a valid cycle or not remains to be seen but it definitely corresponds with the normal end of September drop. Whatever the reason you want to blame on the selling you have to admit that the market sentiment has taken a negative turn. That turn may not have much farther to go before it reaches the first pause point.

The Dow stopped falling at 9300 Friday and that was the initial support point we have been discussing. Should the 9300 level fail and I think that could happen next week we could easily see the 25% retracement level at 9100 be the next pause point. I am too bullish despite my skepticism over the rate of recovery to expect the Dow to break 9000. There is simply too much support between 9000-9100 for the bears to break. It is possible but we should see a huge buy the dip move between 9000-9100. Should that break it could severely damage the bullish case and a rapid drop to the 50% retracement level at 8550 could result. Again, I do not expect that but we need to be aware of the potential. One critical note from Friday was the break of the Dow 50-dma at 9350. It was actually broken slightly on Thursday but the Dow rebounded to 9358 on Friday and then failed again significantly. This should be seen as a definite sign of more weakness ahead.

Dow Chart

The Nasdaq was the biggest loser for the week but it is still in danger of dropping further. The next support is 1750 which is about 42 points away. The most likely target is still the risk range between 1600-1650. That sounds terrible but even the worst case drop to 1600 is only another -10% drop and considering the gains would just be a normal October correction. The Nasdaq broke a critical level on Friday and closed under 1800. This was a psychological level and was critical for bullish sentiment. Every century mark the index gives up puts it just that much farther from 2000 in the eyes of the bulls. The odds are very good we are not going to drop straight to 1600 next week or the week after. Any drop under 1750 will be accompanied by plenty of kicking and screaming and dip buying. The Nasdaq has not broken the 50-dma at 1775 but it is very close.

Nasdaq Chart

The broader market index of the S&P came within 2 points of decent support at 992 on Friday. The next critical support is 975 and 965. The 975 level should be a substantial stopping point and we could see a decent bounce. Under 965 support is pretty thin until 943 or so but if we break the 965 level the market will have worse problems to deal with. The S&P also broke its 50 DMA at 1001 on Friday. It was support in late August but has already failed in the current drop.

S&P Chart

Next week is filled with economic reports that could be critical to sustaining the longer term rally or accelerating the dip. Monday is light with Personal Income and Spending but the pace picks up on Tuesday with NY-NAPM, Consumer Confidence, PMI and Risk of Recession. Wednesday has ISM, Construction Spending and Challenger Layoff Report. Thursday has Jobless Claims and Factory Orders followed by Nonfarm Payrolls on Friday. The biggies of course are the NAPM, ISM and Nonfarm Payrolls. ISM is expected to be flat and that should raise some eyebrows. If the GDP is going to blow out at +7% then why should the ISM show no growth? Could be some reeling in of expectations. The Nonfarm Payrolls report is expected to show a loss of -25,000 jobs. Last month they were expecting it to be flat and it lost -93,000. If they miss on the downside again it could cause concern. The upside would be another serious drop in jobs could provoke the Fed to launch another stimulus program. I doubt it would be a rate cut but they might feel driven to do something else to provide stimulus.

For next week traders should look to be light on their feet and not get married to any longs OR shorts for that matter. With the previous bullishness in the market the volatility could be huge. Whenever I say that I get emails saying "what does that mean?" It is a polite way of saying we could move a hundred points in either direction at a moments notice. You never know what level will trigger a monster buy program that causes shorts to run for cover on heavy volume. Also, for every buy program there could be a hedge fund just hoping for the next rebound to dump another load into the bounce. This erratic behavior means you can be stopped out on both longs and shorts in the same day and possibly more than once.

The best plan for the next two weeks is sell any unreasonable spikes and buy any bounces off support. The chart above shows an example of an unreasonable spike. After two days of declines a strong buy program triggered at 985 in the middle of the day and the shorts were caught completely off guard. The buy program was in response to the unreasonable drop at the beginning of the day which was also totally out of character. So buy unreasonable drops, sell unreasonable spikes and buy known support levels. That support on the S&P, rather use that than the Dow for obvious reasons, is 990-992, 975, 965. Resistance is 1012, 1020, 1030. Sell resistance, buy support and take profits early.

Enter Very Passively, Exit Very Aggressively!

Jim Brown



 
 



Market Wrap Archives