Last week we celebrated the one-year birthday of the new bull market. This week we celebrate the 16 year anniversary of the October-19th market crash of 1987. Stocks dropped -508 points, -23%, on that Monday and traders were caught completely off guard. The market had just set a new all time high and the drop was made worse by an all time high of stocks bought on margin. With stocks only a couple days from recent highs and margin debt at an all time high again some traders felt the drop on Friday could have been fears of a repeat.
Dow - October 1987
October Crash - Intraday
While nobody expects 1987 to repeat 16 years later there are professional traders who remember that day and probably take precautions each October. Some of those precautions this week could have been taking some profits off the table on Friday. After all the markets are very extended and many traders could quit today and have a very good year.
Unlike 1987 we are doing much better economically than we were just a few months ago. On Friday Residential Construction rose to 1.89 million units amid another spurt in buying prompted by last months temporary dip in interest rates. This is a huge number for this late in the cycle and only 2,000 away from the record June rate. Building permits declined slightly as we near the fall weather slow down.
The new highs in the market helped boost Consumer Sentiment to 89.4 from 87.7 in September. Both current conditions and expectations rose with present conditions soaring to 102.2. This is a very strong survey and represents a widespread feeling of economic improvement by consumers. Despite the war, yes it is still underway, unemployment and rising energy prices the average consumer feels pretty good about the future. The market is strong, interest rates although higher are still very low and you have dozens of talking heads on daily TV talking about the economic recovery and +6% GDP. The yellow brick road could need to be widened if this euphoria gets any stronger.
Despite the prior comments that euphoria could evaporate in a moment with another terrorist attack, market crash or the failure of the economic recovery to appear. Yes, despite the better than expected earnings in this cycle there are still hushed conversations in dark places about the chances of a real recovery. Those conversations are likely taking on much more relaxed tones with the top line revenue numbers for S&P companies rising +8% for those already reported. Actually the pressure to perform is easing as the earnings parade continues to build. Estimates for the 3Q were +16% two weeks ago and with 92% of the companies meeting or beating that number has risen to +20%. Very strong earnings even if they are being compared to a weak quarter in 2003.
There have been some stumbles and there are some clouds on the horizon. The misses have been spotty and sporadic with only a few in the high profile names. On Friday Mohawk Industries warned that there was still uncertainty in consumer confidence trends and unemployment continued to depress sales. The carpet company lost -$4.60 or -6% in heavy trading. XL Capital, a reinsurance business, slashed forecasts for the 3Q due to stronger than expected losses. The company lost -$6.03 or -7.6% on the news. SUNW and EBAY were under pressure after their earnings reports despite the earnings meeting or exceeding estimates. EBAY dropped -5% after giving guidance that was less than what the street expected. As companies like EBAY become more mature the astronomical growth rates of the early years fade and while still good they do not live up to investor hopes. EBAY is currently trading at a PE of 78 using 2003 earnings. CAT lost several of its lives with a drop of nearly -$6 after failing to reward investors to the level they expected. In Q2 CAT earnings increased +75% and CAT closed at a new 52-week high the day before announcing earnings this week. Everyone expected another blowout performance. Instead they only saw a gain of +4% this quarter and raised estimates to $3.00 for the year and guided to a +10% growth rate. Analysts were expecting $3.15 for the year because of the 2Q gains. They also missed street estimates substantially for the 3Q. DCLK missed estimates and guided lower and added pressure to the Internet sector in front of the AMZN earnings next week.
After months of market gains the "valuation" downgrades are beginning to fly. Sears was cut by Prudential despite strong improvements in their retail model. This is just an example but the trend is beginning to heat up. With many stocks up +50% or even +100% from their bear market lows they are low hanging fruit for analysts trying to get their name in print. This trend will intensify by the end of next week when nearly 70% of companies will have completed their earnings confession.
Friday's market action was not unexpected. The lack of a real and sustainable bounce over the last five days was beginning to suggest that all the good news was priced into the market and the bullish bloom was fading. The sell off did not occur on strong volume with only 3.6 billion shares traded across all markets but that volume was 4:1 to the downside. That was the strongest ratio in either direction since Sept-26th. Decliners beat advancers over 2:1. The worst indicator for the health of the market was one I discussed positively just a few days ago. The Russell 2000 lost -9.28 (-1.7%) after stalling for four days at a new three year highs. By itself this would not be a material move but it is a reversal of the strong trends from last week. Funds were pouring money into small caps when they would normally be cutting back on positions before their fiscal year end in two weeks. We do not know if this was just profit taking by different funds or the leading edge of that suspected portfolio reshuffle. It was a dramatic move from an index that has been so strong.
The Dow has tried to climb over 9800 for four consecutive days and on Friday it lost ground to trade at 9701 before seeing some short covering at the close. A -69 point Dow drop after +500 points of gains over the last two weeks is nothing. It is barely legitimate profit taking and should not be construed as anything else. We can speculate that it could be the leading edge of a bigger October event but it would just be speculation.
Dow 60 min Chart
The Nasdaq suffered more than the Dow by losing nearly -2% or -38 points and closing in on 1900 once again. Tech stocks that disappointed or in some cases surprised with earnings this week were getting killed as investors raced for the exits. Losers on Friday for instance included DCLK -24%, RSAS -20%, WEBX -18%, SPRT -17%, BRCM -8%, PXLW -8%, MRVL -6%, RMBS -6%, ALTR -6%. Add in EBAY -5% and AAPL -8% and the index never had a chance. If anything this could be the leading indicator for the future of the market. These companies were sold despite good news from several. The tech sector and the market have very high hopes already priced in and once those earnings are out those hopes are meeting reality. The reality is great earnings across the board but not great enough to protect stocks from potential profit taking.
Next week we have over 700 companies reporting earnings, most in the first four days. Most will meet or beat the street if the current 92% average hold true. There are no material economic reports and we will be left to fixate on the individual earnings and watch as the winners and sinners hit the tape after earnings. Whether those stocks will be rewarded with cheers or catcalls is up to investor expectations. Intel, helped power techs on Wednesday with its very strong report but closed Friday at a three day low. The 15 min of fame can be very fleeting and investors are very demanding.
With options expiration on Friday we should see a very active open on Monday. Funds who sold covered calls on stocks while hoping to squeeze a couple more dollars of profit out at the top should have those stocks called away because of the market gains over the last four weeks. If they do this on stocks they are planning to sell anyway then being called away prevents having to sell them. Depending on how widespread this tactic was it could be a volatile Monday as those stocks are put back into circulation by the option holders.
Either way next week promises to be very volatile. With 700 earnings reports, almost no economic reports and only two weeks to go before fund year end anything can happen. Based on my email I know the bullish sentiment is alive and well. With margin debt at an all time high many of those bulls have bet it all on the 4Q recovery. That puts a lot of stock in weak hands and according to all reports economic conditions are improving but still challenging. GE, CAT, INTC, IBM and many others all repeated the same story. "Signs of economic stabilization but too soon to call it a recovery." It is like they all have the same speech writers. If you are a hard core bull you are thinking I am crazy. I had an email to that effect on Friday. Something along the lines of "Are you on drugs? Everybody knows we will be at 11,000 before the end of the month." You know, it is possible. I cannot concoct a scenario that would make it happen but then the market does not ask me for direction. I just try to paint the picture as I see it and let the readers make their own decisions. I thought Thursday would be the high for the week but CAT and IBM spoiled the party and Wednesday turned out to be the winner.
I guess it all boils down to this. We know that some companies will beat estimates next week and some will miss. The question is whether enough companies best estimates by a wide enough margin to offset the negative sentiment from those who don't. Who is announcing next week that has the power to explode the market over 9800? MMM, MSFT? What could they say that would be better than the Intel earnings? At this point it would have to be a lot better because the excitement is beginning to fade. Even if we do see some profit taking over the next couple of weeks it is just PROFIT taking. It will not be the end of the world. Just think of it as a buying opportunity. There are millions of investors sitting by their PC this weekend just hoping there will be a normal October buying opportunity so they can get that second chance for a cheaper entry. Those reluctant investors who missed the last several dips and have been watching the Dow close in on 10,000 are chomping at the bit to go long. If it comes there is a lot of money still on the sidelines and I would be very surprised if that 10K level was not in our rear view mirror by year end. Until then keep those seat belts fastened because the lead car in this thrill ride may be just about to disappear from sight.
Enter Very Passively, Exit Very Aggressively!