Option Investor
Market Wrap

OK, Now What

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        WE 9-03         WE 8-27         WE 8-20         WE 8-13 
DOW    10260.20 + 65.19 10195.0 + 84.91 10110.1 +284.79 + 10.02 
Nasdaq  1844.48 - 17.61 1862.09 + 31.07 1831.02 + 73.80 - 19.67 
S&P-100  541.06 +  0.18  540.88 +  4.84  536.04 + 15.32 -  1.11 
S&P-500 1113.63 +  5.86 1107.77 +  9.42 1098.35 + 33.55 +  0.83 
W5000  10820.88 + 65.86 10755.0 +106.22 10648.8 +344.09 -  3.18 
SOX      357.84 - 24.50  382.34 -  3.66  386.00 + 19.35 - 20.23 
RUT      556.24 +  4.57  551.67 +  3.75  547.92 + 30.53 -  2.26 
TRAN    3141.85 + 33.05 3108.80 + 17.93 3090.87 +123.95 +  0.84

The conventions are over and the Olympics have ended. The biggest event risks for the year have passed. The Jobs report is history and the dog days of summer have turned into crisp clear days of fall. We are two thirds done with the third quarter and a full two months remain before the election. The markets are finally free to trade on their fundamentals. Now there is some real event risk!

Dow Chart - Daily

Nasdaq Chart - Daily

There were only two economic reports on Friday and the biggest report was the Jobs number. The headline number of +144,000 jobs was only slightly less than expected and actually surprised quite a few analysts. The July numbers were revised up from 32K to 73K and the June number was revised up from 78K to 96K. Including the revisions this amounted to a net gain of +203,000 jobs. Traders were more stunned than excited and you got the feeling nobody believed it. The unemployment rate fell to 5.4% but it was due to a reduction in the labor force rather than more people finding jobs. The number of workers actually employed rose only a very weak +21,000 compared to the +629,000 gain in July.

The revisions to the two prior months suggests Greenspan's soft patch was not as soft as previously expected. The Fed kept telling us jobs were being created yet traders remained skeptical. The muted reaction on Friday may have appeared to be continued disbelief but I believe it was just very light pre holiday volume instead. With summer over the jobs risk should diminish. The ramp up for the holidays as well as the normal seasonal hiring bounce should continue to give us positive numbers until spring. This August gain will insure another Fed rate hike on the 21st. The Fed Funds Futures had been showing the potential for only a 1.75% rate by year end but after this report they immediately jumped back to a full 2.0% by the Dec-14th meeting.

More disconcerting than the Jobs report was the ISM Services report that posted a headline number of 58.2 and a drop from last months 64.8. This was well below the consensus estimates of 62.9 and twice in the last three months that we have dipped below 60. Considering the services sector was thought to be bullet proof this is a disturbing drop. New Orders fell to 58.6 from 66.4 while most of the other components remained stable. This could be just a seasonal summer lull and the Sept report will be scrutinized carefully for further signs of weakness. Our economy may actually have reached self sustaining status but it may be to soon to push the life support equipment out into the hall. The economy is breathing on its own but not yet ready to climb the wall of worry ahead.

There are no material economic reports next week until Friday's PPI. Lots of small ones but they should not impact the market. Of more concern to us is the coming earnings warning season. The warning season should begin in earnest the week of the 13th but as you may have noticed we have seen quite a few already and the pace is accelerating.

The Intel news was mostly trumped by the positive Jobs report but the SOX still managed to drop -5% intraday to 357. Intel opened at $20 and held that level most of the day. Adding to the SOX decline was warnings from Cypress Semi and 3Com. CY fell to a new 52-week low after saying weak demand and soft customer orders would cause them to miss prior estimates. CY said they would earn in the range of 11 cents where analysts had been expecting 26 cents. That is some serious order weakness.

3Com, a competitor to Cisco and Juniper, cut its forecast and reversed its prior guidance. In June the CEO had said conditions were improving and gave revenue estimates of $183 million for the quarter. They now expect revenue of only $160-$164 million. This is another serious change in outlook. They also said margins would be lower than expected.

EFII warned on Friday that profit and revenue would fall short of analyst estimates. EFII now projects earnings in the range of 12-14 cents. Analysts were expecting 26 cents. EFII fell -4.30 to $16.30 in heavy volume.

On Thursday IDTI warned and that suggests we could see a warning from PMCS. They have the same customers and address much of the same markets. With the Intel warning of a reduction in capex spending we could see warnings from AMAT and others in the chip equipment business. The dominos are lined up could begin falling soon.

The coming weeks have not been kind to the markets in the past. In fact Friday was the anniversary of the Dow's high in 1929 when it topped out at 380. We all know the history of the market and the ensuing crash. The Dow retraced -89% of its height to reach a whopping low of 42 on July-8th 1932. It took more than 25 years for the Dow to reach the 380 level once again. Most of us were too young to have been traders back then but imagine an 89% drop. Just to return to the prior level requires a 900% gain.

There is nothing in the cards to suggest we will see a drop of that magnitude again in this decade but there is always a chance of a correction in our future. Despite putting all the summer event risk behind us we may see a different market when traders return from vacation next week. There are many conflicting conditions that should provide an active market over the next four months. It should be directional although not always in the same directional. The potential for a flat and boring market is very slim.

There are huge amounts of money waiting patiently on the sidelines. According to some analysts cash could be at record levels for recent times. This should keep a bid under the market until the election although we may not see it immediately. Corporate earnings are rising although comps are declining. That means we are seeing an increase in profits on a quarterly basis but that rate of increase is just lower than the same quarter last year. This is one major cause of the current flurry of warnings. Is it bad if your earnings only increased +15% in Q3 this year compared to +20% in Q3 last year? Last year we saw nearly $100 billion in tax rebate cash hit the retail sector and that sent a ripple of profit through the economy. Remember the GDP was up +7.4% last Q3 and we are going to have to struggle to hit +3% this year. Bottom line I do not feel that a lower rate of profits is a material reason not to buy stocks as long as profits are increasing overall.

However, we often talk about PE compression and that is what we may have ahead of us. This means stocks are priced for a specific PE ratio, say 20, based on their expected 2004 earnings. Sometimes it is based on 2005 or even 2006 earnings at this point on the calendar. This PE ratio assumes an historical rate of growth. The strong Q3-Q4 profits last year have skewed that historical PE ratio to a higher than normal ratio. Once the warnings begin to appear on a broader basis there will be PE compression cycle where stocks still racing ahead will attract investors and those slowing will lose investors. Why am I going through this lengthy discussion today? Because September and October are typically when this rapid PE compression takes place.

Summer months tend to drag on earnings and this puts a higher number of earnings warnings into Sept and earnings misses into October. This is the period where mutual funds tend to shuffle the deck and discard the names out of favor and add those names currently on fire. For the market Sept/Oct is a big garage sale, or yard sale as you would say in some parts of the country. Once the portfolio has been swept clean and the sectors balanced neatly on the shelves the managers go shopping to fill those blank spots in the pantry.

This is not a bad thing for the markets it is just how they work. If you are a gardener it is similar to a pruning. I know each year my fence of climbing roses tends to look pretty straggly by October. Those limbs that ran wild can be 5-6 feet long and ready to snag anyone that walks by. If I don't prune them back to the same level as the rest they will be laying on the ground next spring and the entire bush will suffer. To put this in perspective funds are preparing their list now of those stocks that have run away from the market and may be overextended or they just have too much cash/profit tied up for the expected growth ahead. They need to prune these fast growers and invest in some more plants to expand their garden. This decreases their risk by reallocating the cash and gives them a wider exposure to future fast growers.

While the Sept/Oct decline does not always happen the potential is very strong. Everyone remembers the rally in 2003 where the market exploded off the lows in March and never looked back until February of this year. Well that may not be exactly correct. Even in the middle of that very strong directional move September had two significant dips and one in October. The Dow reached a high of 9609 on Sept-4th and dropped -240 points to 9380 on the 12th. It rallied again to a high of 9686 on the 19th but then dropped -456 points to a lower low of 9230 on the 30th. The first two weeks of October saw a strong rebound of +620 points to 9850 on Oct-15th. The damage was not over with a -350 point drop over the next six days to 9497.

I recapped those moves to prove a point. We were in the midst of a very bullish period in the market and the Dow managed to move 1666 points in four direction changes over the two month period but only finished +278 points higher on Oct-30th than where it closed on Sep-2nd.

The point I am trying to make is that regardless of your market bias, bullish or bearish, we are entering a period where volatility reigns. About the only guarantee we have is the promise of a post election bounce in Nov/Dec. That potential bounce is a historical trend and should keep the real bears at bay. Remember the overriding market imperative for the next couple months is to be fully invested by Halloween. If you agree with that then you should have ample opportunity to initiate positions over the next six weeks. I say six weeks because the elections give us a target date for the move and we know the majority of funds will not wait until the last minute. They will be moving quickly over the next 4-6 weeks to shuffle their portfolios and get ready for a typical year end rally.

This also suggests the selling could accelerate into September. The key here is the earnings warnings. This is what institutional investors are looking for to give them the final clues as to what to dump and what to keep. The roadmap is clear today only there are no cars yet on the road. Traffic should pickup significantly next week.

The Dow appears perfectly poised for the next two months of activity. The recent rebound took it back to very near the downtrend resistance since February. The Dow closed at 10260 on Friday and that downtrend resistance is lurking just below 10350. If we do get the historical post Labor Day bounce then 10350 would be well within range.

The Nasdaq is the weakest link here with the Intel news knocking it back to 1845. Strong resistance is currently 1890-1900 and with the chip weakness it would take a major reversal to get us back to test that resistance.

SOX Chart - Daily

The SOX is the anchor holding the market down and it may not be long before we begin springing other leaks. The SOX set a new 52-week low today with a close at 357.91 and is very close to my target from last week of 342-350 for decent support. With every broker on the planet negative on chips it may be about time to pick some up. I think that thought process will start to appear once we break that 350 level. Should conditions worsen there is risk to 300 but I think there is too much money on the sidelines for that to happen in 2004.

So what now? Traders should look for a potential bump next week on event risk relief and then the bears may begin their fall feast. For long-term investors I would look for stocks I really want to own and start staging orders at levels you would be comfortable owning the stock. I did not say levels where you think they would bottom because unless you have very accurate crystal ball nobody knows those numbers. We need to pick entry points where we would be comfortable owning the stock or option for the next several months. For instance I would love to see EBAY pull back to its 200dma at $74 but with it currently ay $89 I am not holding my breath. To knock EBAY back that far the market would have to suffer a major retracement and I don't see it.

Next week get out your shopping list and get ready for the blue light special to appear soon. Those of you that go both ways should look at any post Labor Day bounce as an opportunity to unload the dead wood. Get ready to add a few put options to keep that adrenaline flowing while we wait for the bears to finish feasting and go into hibernation. Have a great weekend!

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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