Option Investor
Market Wrap

New Low

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       WE 10-22        WE 10-15        WE 10-08        WE 10-01
DOW     9757.81 -175.57 9933.38 -121.82 10055.2 -137.45 +145.41 
Nasdaq  1915.14 +  3.64 1911.50 -  8.47 1919.97 - 22.23 + 62.72 
S&P-100  525.16 -  6.64  531.80 -  6.67  538.47 -  4.64 +  8.74 
S&P-500 1095.74 - 12.46 1108.20 - 13.94 1122.14 -  9.36 + 21.39 
W5000  10748.04 - 90.63 10838.7 -125.85 10964.5 - 94.18 +220.40 
SOX      395.16 + 13.79  381.37 -  8.15  389.52 - 12.39 + 19.36 
RUT      567.77 -  0.65  569.42 -  6.23  575.65 -  9.38 + 19.06 
TRAN    3371.94 + 19.26 3352.68 + 16.68 3336.00 + 37.20 + 96.69 
VXO       16.09           15.89           14.95           12.55 
VXN       21.36           21.80           20.69           18.91 

It is official! The Dow closed at the low for the year on Friday at 9757. The gains for the year have been erased and we are only 157 points away from erasing all the gains from the Nov/Dec rally last year. That rally saw a low of 9600 in November and ended in February at 10656. A +1056 point gain on the verge of being completely erased. Please pinch me, I want to wake up from this nightmare.

Wilshire 5000 Chart

Dow Chart

Nasdaq Chart

There were no economic reports to sway trader's feelings on Friday and there were little in the way of stock events. Earnings slowed and there were no high profile earnings misses. Some blamed oil as it traded over $55 for most of the day but I believe it was more of the scapegoat rather than the reason.

The main story of the day was the Google explosion and a +$25 gain in the stock price. Nearly 37 million shares traded and there are only 31 million or so available to trade. Short interest was obscenely high and it appears they all tried to cover on the same day with many shares trading hands several times before the day was out. The press could not decide to praise Google or crucify them given the ramp to $180 intraday. Brokers were tripping over themselves raising price targets to between $180 and $200 now that their original targets in the $125-145 range were badly missed. Valuation was discussed over and over with comparisons to other Internet stocks the norm. This is the way they stack up.

Amazon @ $34.50 2005 PE is 29
Yahoo @ $35.00 2005 PE is 72
Ebay @ $96.00 2005 PE is 62
Google @ $175 2005 PE is 45

Should Google rise to $250 it would be a 2005 PE of 66. The gains on Friday were not related to valuation as much as they were related to the monster short squeeze. Many traders had expected them to produce disappointing earnings and plummet from the lofty levels of last week. Long call options generated even more short covering activity. Option volume was huge. The Nov-170 call had open interest of only 4682 but volume Friday was 8930. The 180 call had open interest of 1556 but volume of 7964. Multiply this for all the months/strikes and you can see how the panic developed. Traders trying to use normal logic in trading the stock were creamed. For instance, traders long the stock but expecting the bounce to fail could have sold covered calls at the $165 open expecting to collect the premiums and laugh when the stock rolled over. As the stock shot up to $175-180 and people started talking about $200-250 they raced to buy the calls back thereby adding to the volatility they were trying to avoid. It was a crazy day that brought back memories of the Nasdaq bubble. GOOG increased its market cap by $7 billion by the close.

Unfortunately investors may have found Google's legs but they could not find any coattails. The Google windfall did not help the market or even the other stocks in its sector. AMZN dropped -4.87 to $34.50 after warning that earnings were slowing. YHOO fell -$2 off its high and closed down -75 cents as traders ran to the new kid on the block. EBAY fell -$6.16 off its Google induced opening high of $102.12 to close -3.68 for the day at $95 despite great earnings earlier in the week. Traders took profits on the old timers and I a sure a few dollars were thrown at Google in hopes of another $400 Amazon replay.

Spitzer took aim at another sector on Friday in an effort to be an equal opportunity prosecutor. Music companies came under fire for investigation into schemes that could be seen as pay for play which is illegal. EMI said Spitzer was investigating how music companies influence what songs are played on the radio. They indicated they along with other music companies were cooperating fully in the investigation. The investigation centers on how they hire and compensate middlemen to promote their music in an effort to sidestep U.S. laws against pay for play or bribing of broadcasters and DJs. One industry source said the investigation would be a good thing if it eliminated the practice because companies pay hundreds of millions of dollars per year to these middlemen.

In a news release that will be bad for consumers INTC cancelled its plans to produce its liquid crystal chip for big screen TVs. This new process was going to cut production costs of wide screen TVs much like their processor chips did for personal computers over the last two decades. Intel had delayed it twice and finally cancelled it saying the investment and time would be better used in other areas. Intel just recently dropped plans to produce a 4ghz chip scheduled to ship early in 2005. They said they could produce better throughput gains using other processes rather than concentrate on the faster chip. Experts have pointed out recently that the current generation of 3+ghz chips are not being used to full capacity due to limitations in other hardware and software on current PCs.

I mentioned on Thursday night that the SOX had resisted the broad market sell off and was holding near resistance at 410 in what could be a potential breakout ahead. After Friday's chip wreck that seems less of an option than before. The SOX failed at that 410 resistance and fell back to 395 after the flood of warnings on Thursday night. The sector had been bullet proof since the Monday low but the combination of the BRCM, XLNX, KLAC, LSCC, MCHP, IDTI and TQNT warnings all on the same day was too much for chip buyers to bear. The SOX fell -14 points BUT that was less than it gained on Thursday before the warnings. Chips may have been weak on Friday but weak is relative and the index closed up +14 for the week and well off its 375 lows from Monday.

So what did cause the market decline? I have several suggestions that may have contributed to the decline. First there was the SOX decline on the chip warnings. No big deal and it appeared to be simply normal profit taking from the weeks pre earnings gains. Another contributing reason was the high oil prices and heating oil hitting record highs at $1.586. Government data this week showed home heating oil inventory levels to be -12% below normal and analysts fear a cold snap as we near Halloween could push those levels even lower. Lately equities have been ignoring oil prices but the new warnings may have been a minor contributing factor.

Earnings are not coming in as strong as expected. With 52% of the S&P already reported the most optimistic calculation shows average earnings at +15.2% growth but there are firms publishing numbers at +10.8% as well. The average earnings beat is only +2.2% compared to +3.0% on a normal basis. We currently have a 2:1 ratio of guidance warnings compared to a normal 3:1 ratio of companies raising estimates. While this was not expected to be an exciting quarter most expected it to be better than what we are getting. With most companies guiding lower the earnings deceleration is coming a quarter earlier than most expected. Most analysts expected Q4 to be decent and the decline to +3% growth to begin in Q1.

Bonds hit a seven month high on Thursday and ten year yields have been under 4.0% for three days now. The bond rally is creating uneasiness in equities when you realize we are 12 days away from another Fed rate hike. What do bonds know that we don't is the worry among equity traders? Are bonds predicting an economic decline? If so then the gains are from traders shifting out of equities and into the safety of bonds until the future brightens.

The cloudy future could have a lot to do with the current election predictions. RealClearPolitics.com averages the various surveys on a weekly basis and they are showing a very scant 2% lead for Bush. Since the Dow has fallen the two months before the election 9 of the last 10 elections where the incumbent lost we could be seeing a higher level of caution enter the markets as we near the election. The market could be predicting a change in administration ahead. With only a week to go and no clear leader the various market factors specific to each candidate cannot be brought into play. Nobody knows which way to play. Are taxes going up or down? Will spending increase or decrease? Will drug companies be forced to sell drugs cheaper? What will happen to social security, health care, etc? Nobody knows and hedge funds don't know where to invest their $1.2 trillion in cash currently under management. Mutual funds who have thinned their portfolios heading into their October year end don't know if they should invest in health care, energy, financials or homebuilders. With the economic outlook cloudy there is no clear sector other than commodities that suggest a reasonable return. With China still growing at a +9.1% clip based on this week's data the commodity sector is not likely to slow. That leaves equities starving for dollars.

Historically the end of October sees a ramp into the election when there is an obvious leader. No leader equals no ramp. We are getting to the point where the undecided voters will have to get off the fence and make a commitment. The surveys will intensify next week and hopefully that commitment will be reflected because left on our own next week could get ugly.

The Dow closed at the lows for the year and the fourth major new low for the current down trend pattern. The general consensus expected the Dow to hold at the 9800 level and Friday's close was a wake up call for traders. The Dow now has potential to trade down to 9700 or even 9600 to complete the current pattern. With all the indecision about oil, economy, earnings and election it could easily hit 9600 by Tuesday. I am not saying it will because there are other circumstances at work here. Once a rebound begins, if it begins, there is strong resistance at every 50 point increment from 9900 to the top of the pattern at 10350. Despite the -107 drop on Friday there were only two Dow components that lost more than $1. AIG -1.75 and MMM -1.72. 28 of the Dow components ended negative but the majority were only down 50 cents or so. It was not a washout or a landslide regardless of the final numbers.

The Nasdaq is still in much better shape and holding over strong support at 1900. The -38 point Friday drop still left it +13 for the week. It appeared to be chip led profit taking more than tech dumping. The SOX and the Russell continue to provide support and until that changes we will continue to see bullish divergence. The Nasdaq has multiple supports all converging between 1885-1915. The 100dma at 1907, 50dma at 1885, uptrend support at 1915 and horizontal support at 1900. This congestion range should withstand any casual selling and only be broken with a serious market downdraft.

SOX Chart

Russell Chart

I mentioned the external circumstances I believe were at work on Friday. Many mutual funds have October year ends and they shuffle their portfolios in October and sell some winners to offset the losers also sold. A fund holding EBAY for instance has a 100% gain from the $50 price this time last year. How much higher can EBAY be expected to rise? Probably not another +100%. For funds that found themselves with a bunch of MRK, MMC, AIG or tech stocks that imploded rather than exploded then EBAY, RIMM, SYMC, etc, become cash machines to fill those potholes. They certainly do not want to sell all their winners because they want to show how smart they were by having winners on their year end statements. But nothing prevents them from paring those positions to smooth out the rough spots. Thus the big losses in EBAY, SYMC and RIMM to name a few. Even energy stocks lost ground despite a new high for oil over $55. This could be just normal October portfolio adjusting.

If they are going to make adjustments before their year end they only have five days left. Last week probably represented this pruning process and the Thursday earnings flood of nearly 400 companies gave them plenty of guidance on which stocks to dump. Hopefully that dumping process has been completed and funds will be shopping again next week.

We need to also keep in mind that there has not been any terrorist event designed to impact the election as they had in Spain. If they are going to try to sway the election this is the week. Personally I think any event would only help Bush and that may be what is holding them back. This could also have been a factor in our market weakness this week. Fear of the unknown is always market negative.

Speculating on daily market direction in October is a fools errand. Historically bottoms are made in Oct and Nov/Dec are usually up. Without a crystal ball picking that October bottom is best done in November when hindsight is the best. I would love to say Friday was a final flush job but there are far too many factors to make that call. I still believe the market will rally after the election but with no clear leader the rest of October will be a tossup. However, if you are a fund manager with cash to invest the Dow represents the most depressed big caps in the market. Hunting for bargains in the Dow is like trying to find the last edible piece of popcorn among the scorched kernels in the bottom of the bag. With the exception of HD, VZ, JNJ and XOM the rest of the roster offers risk/reward profiles only Mother Teresa could love.

That poses a problem for the rest of the year. Any Dow rally could be weak and divergence from the other indexes is almost guaranteed. While prior analyst estimates suggested 10750-11000 would be the year end range I would be happy to just see four positive days out of every five so as not to be a major drag on the rest of the indexes. Triple digit days are not required and probably will not be seen. Just let the Dow stay positive and disaster free leave the long distance driving to the Russell.

Just keep repeating this to yourself. Just one more week, just one more week. Just let this torture pass and get the election behind us so investors can concentrate on the future. If next week ends positive then consider it a gift from the market and a sign of better times ahead. Should we close lower than Friday's 9750 you can consider that a sign as well. A sign the party may be over.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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