The Option Investor Newsletter Monday 06-12-2000 Copyright 2000, All rights reserved. Redistribution in any form strictly prohibited. Posted online for subscribers at http://www.OptionInvestor.com ****************************************************************** MARKET WRAP (view in courier font for table alignment) ****************************************************************** 6-12-2000 High Low Volume Advance Decline DOW 10564.20 - 49.90 10652.60 10564.20 758,275k 1,402 1,481 Nasdaq 3767.91 - 106.96 3892.05 3767.88 1,280,486k 1,530 2,563 S&P-100 774.25 - 5.45 774.25 774.25 Totals 2,932 4,044 S&P-500 1446.00 - 10.95 1462.95 1446.00 42.0% 58.0% $RUT 508.51 - 14.55 523.79 508.20 $TRAN 2781.50 - 8.67 2815.90 2779.40 VIX 25.37 + 0.18 25.94 24.82 Put/Call Ratio .48 ****************************************************************** No Investor Commitment Keeps Prices in Flat to Down Mode Not a day for the record books, but certainly one for the hammock, investors sent stocks mostly lower today as earnings warnings sounded in the technology, raw materials, and retailing sectors. Today's losers include one of Jim's "big ones that got away", MSTR, not to mention CTXS, BCC, HD, HLIT, and INKT . The price of oil surging over $31 per barrel and the Justice Department's refocus of its anti-trust guns from Microsoft to MasterCard didn't help either. The latter isn't as big of a deal in the immediate picture. Still, what the heck happened? Starting with MSTR (-23.31, $38.88), Merrill Lynch submarined this recently re-floated boat by blasting last week's financing hype and noting that it sees no change in the fundamentals or the financing of the company. It noted too that customers were holding back from purchases pending more clarity on their accounting issues. Ouch! Recall that it was news of MSTR receiving a new round of financing that popped the stock back over $60 last week. Not to be outdone, CTXS delivered the Street its biggest disappointment by announcing before the markets opened today that they would not come close to meeting estimates of $0.21. Instead look for $0.09-$0.11. The announcement certainly helps explain why their CFO didn't show for a Paine Webber Tech and Growth conference last week. Short sellers moved on his no show. Even if he'd attended, it would have been tough to dodge the hard questions in that environment. Prudential downgraded the issue from Accumulate to Hold with a price target of $20. While no honor to hold the title, CTXS was the most heavily traded issue today on the NASDAQ at nearly 95 mln shares. It may be ugly for them, but those of you in put plays should be partying hardy after today. And speaking of conferences, HLIT too sank its own battleship by noting at a CBIC Open Markets conference that AT&T, one of its largest customers was spending less money on its cable products as a percentage of revenues. Wait a minute, isn't growing revenues and less reliance on a single customer a good thing? Maybe so, but apparently HLIT did not drive home the point to investors' satisfaction. It might not have mattered anyway as investors lately are prone to shoot first and ask questions later. (Aside from HLIT, it bolsters the notion that T has an execution problem that it isn't likely to fix soon.) The buzz also had current earnings estimates coming down as a result of its Divicom purchase from CUBE. HLIT said there is no news from their end to warrant or justify the drop. Nonetheless, shares finished down $18.69 at $38.75 on volume of 28 mln shares, more that 12 times their ADV. OPEC too chimed in, sending oil traders running straight to the bank. Oil inventories are still sinking despite a reported production increase. The trouble is nobody knows how much extra production is going on just yet, and based on the stockpile decrease along with OPEC's refusal to announce a boost in production until their June 21st meeting, we are witnessing a short-term spike in the price of oil. The perceived effect is that it's inflationary and may keep the scales tipped in favor of more interest rate hikes by the Fed. That's great news for oil traders, but lousy for those looking for signs that the Fed won't hike rates again at the next FOMC meeting. Paying over $2 per gallon of gas in the Midwest isn't good either. Also on the natural resource front, Boise Cascade warned last Friday that it would fall short of earnings too - $0.76 rolled back to less than $0.52. It cited slowing wood product and paper sales. While you might think "big deal, it's just a wood and paper company", think of the implications. The Office Max's and Staples of the world are buying less paper. Not only that, with home sales slowing, builder's aren't buying as much raw material; neither are home improvement outlets like Home Depot or Lowe's (HD was downgraded by ING Baring and another brokerage today on softer sales fears). Retailers like TGT, KMT, CC and WMT have already been punished in anticipation of a slowdown. Hello? The slowdown is here! And with raw material suppliers just starting to report weaker earnings, it will take some time to work to the top levels of the economy. So while investor's mistakenly focus on the Fed's next interest rate move, the bigger picture is that a slowdown is in place and we aren't looking yet for a return to the robust markets of February and March, as earnings will likely continue to come in weak throughout more sectors. Fiber optics may escape punishment now and may pay less of a price later on, but that sector too will be like Atlas shrugging the weight of the investment world on their collective shoulders. If you doubt it, just fast forward in your mind to June 29th after the next FOMC meeting. Any increase in rates will be a negative for the economy as we still have four of the last six rate hikes left to filter through, plus the new one Alphonso the Great (Greenspan) announced yesterday (remember, in your mind). Voila' - reduced profits. Next scenario. . .it's June 29th again, and Alphonso pronounces "no rate increase". Party hats and horns? Don't bet on it. That lack of action will likely also come with an implied statement that while inflation is under control, recent hikes are slowing the economy. Voila' - again, reduced profits. The common element here is reduced profits, which is never good for equity prices. This will be redundant from the weekend Wrap, but it bares repeating. If profits are falling, equities cannot rise. Perhaps that's why Merrill Lynch advised clients today that they were moving their model portfolio from 5% cash allocation to 0%, and placing that cash in bonds, not equities. While we would all like earnings season to prop up the prices, it didn't work last quarter and likely won't this quarter either. Therefore it behooves us to become good stock pickers looking for good entry points. If you missed Jim's Options 101 titled "Entry Point, Entry Point, Entry Point" from yesterday, we strongly urge you to review it again. That is your best defense against Mr. Market, and in determining your financial future. That's the big picture. How about the immediate trading future? Lest we sound like growling bears, it was not all bad news today. GLW lit up traders' screens with a bunch of green (+$18, $230) after it pre-announced earnings that would exceed the Street's estimate of $0.69 with a whopping $0.78 to $0.80 figure. No longer casserole-dish maker to the world (that division purchased by Borden in 1998), GLW holds the majority of fiber optic cable market share now. To say that business is growing like a weed would be an understatement. Other stocks including JDSU (+$5, $115.56), SDLI (+$11.97, $261.97), NEWP ($+5.75, $85.50), and FIBR (+$9.39, $68.15) all moved up in sympathy. Because this sector is in the sweet spot in the Internet/bandwidth revolution, it is not seeing the slowdown that is clearly visible in the B2C Internet sector. Barely noticed by the mainstream press, we were also glad to see an old favorite QCOM, finally get a foothold in China. China's number three wireless company, China Unicom will adopt QCOM's third generation CDMA technology - to which we say smart move. QCOM gained $2.63 to close at $81.69. Anyone notice that QCOM has been climbing steadily over the last seven days, whereas the rest of the market has declined slightly? The sellers appear to be gone. Keep this one on your radar - we will too. Oops, in all the excitement, we almost forgot to report the score. So here goes. The Dow finished down 49 at 10,564 on the second weakest volume day of the year - 774 mln shares. Advancers were about even with decliners (1404 and 1488, respectively) while 66 new highs edged out 47 new lows. Nonetheless, traders favored down volume today at 401 mln shares vs. 323 mln for up volume on the NYSE. Weak volume is indicative that traders and investors both lack any sort of conviction for raising prices. The compressing trading range between 10,800 and 10,300 is still compressing with lows staying flat at 10,300. We had hoped that the Dow might find some support today at 10,600, but the lack of it tends to make us think we'll test interim support at 10,400, then perhaps a bounce to 10,600 just based on the technicals. For what it's worth, the line connecting the highs meets the line connecting the lows on roughly (surprise!) June 28th at approximately the 10,500 to 10,600. Can you say sideways trading? Speaking of sideways, despite a 107-point loss today, the NASDAQ has held a mere 163 point trading range for the last seven days trading between 3730 and 3893. Take out last Wednesday's morning dip and the range shrinks to just 133 points. We can't remember when that last happened, but it makes trading dull, dull, dull. On such a flat day, it's no surprise that new highs were almost dead even with new lows, 78 to 64. Still, for those who can't sit still without trading, this is a punishing time - just ask us! Anyway, the NASDAQ finished down 107 to close at 3761, its low of the day on under 1.3 bln shares. Weak volume and a declining finish aren't a good sign for tomorrow's open. We've been pretty vigilant about reminding ourselves of the possibility of testing the gap from two weeks ago as it was bound to happen soon. We just don't know when. So keep your eyes on the 3725 level. If we get a bounce from there, NAZ could move back up to retest 3875, but the stronger sentiment and technical picture point to a retest of 3600. Today's down volume smashing up volume by almost 3:1 lends support to that likelihood. Be ready. In short, to us this feels like that weightless feeling you get as the roller-coaster car slows at the top of the track. It's likely investors will bide their time until the FOMC meeting despite retail numbers tomorrow and the CPI figures Wednesday, both of which should shoe a slowing economy. While we couldn't hazard a guess over the weekend which way the market will move, today's action has us leaning toward the downhill side. Of course, no sooner do we say that, then the market taps the low end of the range and begins to move upward again continuing the rangebound trading pattern. As I mentioned last week, while Jim is saying, "sell too soon", I'm sticking with "don't buy too soon" a bit longer. Buzz Lynn Research Analyst ************** TRADERS CORNER ************** More On Stochastics By Austin Passamonte To be honest I was a bit surprised at the amount of feedback last week’s little blurb on stochastics generated. Seems like more than a few traders rely on this tool in some form or fashion. Here’s a letter I’d like to share with you: Austin, You're right on the money! It's so nice to have you confirm my trading strategy almost exactly. I've been very successful using candlesticks, stochastics, AND Bollinger Bands. I find setting the preferences on the stochastics to 10,(3),5 really smooth it out. Stochastics are my primary indicator on longer term charts like the daily or 60 minute. Short term I watch for the %K to cross the %D outside the 80/20% lines as a leading indicator. If I'm in doubt then I wait for them to cross the 80/20% lines. But long term sometimes they can cross at or near the 80/20 and still give a good reversal signal. I find this to be a very reliable indicator when trading tops and bottoms. I use 20,2,close on the Bollinger Bands. When the candles penetrate and then pull back from the Bands and the other two indicators you mentioned are positive, it's sure to be a tradable reversal. I've got several filters to prevent false readings, place stops, etc. It's not cut and dry unfortunately. It requires a feel that one gets after months of watching and paper trading. Thanks for your column. It's very informative and I always learn something. (Mike M.) Well Mike, thank you for educating me! I’m going to try those 10/5 settings and see what happens vs. 14/3 standard. Your note also makes several valid points we should elaborate on. First of all, no technical indicator I’m aware of will stand alone and let us trade for high profits. I guess that’s why there are so many of them... who’d need a plethora if any one worked 100%. This is a great example of several tools used together effectively. I wholeheartedly agree with the part about things not being cut & dry. Technical analysis is as much art as science. It does take experience over time to develop a feel for how each indicator behaves in order to accurately predict what may happen next. By his admission, Mike uses stochastics as a crossover buy/ sell signal with favorable results. I tend to use them as a market barometer. Daily chart signals show possible tops or bottoms in the current direction for markets moving sideways. The hint of such a move makes me aware of the given equity’s “temperature” and I watch closely for further symptoms from there. This chart of the Dow from last Thursday’s close is a prime example. I captured it and wrote these words prior to Monday’s market open. Let’s see if we are confirmed our remiss in our outlook later: (Daily chart of Dow after Thursday 6/8 close) The recent rally we’ve enjoyed has shown strength in the NASDAQ but hinted at weakness in the Dow. The major index dropped from a high of 10,823 to close at 10,670, a loss of 153 points from the true range of the day. This led to the loose formation of an “Evening Star” pattern if you squint a little. (The candle from Wednesday isn’t a doji, but is engulfed by Thursday’s bearish candle. Work with me here, please!) The same market behavior caused both stochastic lines to bounce off the 80% mark and turn ever-so-slightly down. Even though Nasdaq continued to show strength I’m not totally sold on the summer rally sprouting long legs. Had stochastics rose above that 80% mark and flat-lined awhile the market would of course been putting in higher highs itself. If this reading is true in front of the PPI release, it shows anxiety is still alive & well out there. Such a brief period of time stochastics spent near 80% may mean any correction could also be short-lived and smaller than the last. The longer this indicator remains buried in an extreme zone the more extreme moves are to the opposite when reversal occurs. Please understand that I really want this rally to exist but If the emperor has no clothes on let’s face it; the fat guy is naked and that’s just the way it is. Can you see why I’m leery of a full-blown, extended rally right now? (Daily chart of Dow after Monday’s close) (Daily chart of NASDAQ, Monday’s close) We can clearly see how the markets have behaved since Thursday’s close. Has any of our foresight come to fruition? You decide. I also use stochastics to enter/exit trades with 10-minute charts as well. If I have some call options near or at my purchase range I often wait for the slow bar to hit 15% or less before entering my buy order. By the time it executes the fast line probably hit bottom or turned to move up, getting me in near the low of that time frame and hopefully for the day. Puts are the exact opposite. I want that slow bar near or at 90% before I click the order. This seems to give me the best chance of buying near the highs for the day during normal market conditions, whatever that is lately. This tactic is out the window during major capitulation. I sell options when the fast stochastic line hits near 100% for calls and near 0% for puts. Watch this stochastic behavior on a 10-minute chart tomorrow and see how price action halts immediately after the line hits these extremes. That doesn’t mean the move is over for the session but if you want out near that price right now you’ll notice it almost always hits the maximum for that market when using this method. Don’t trade it before you verify for yourself, but I’m pretty sure I know what you’ll see. The other indication I use stochastics for is divergence warning. If stochastics on an hourly or daily chart are making new lows prior to the last time they were down to this level but the underlying isn’t making lower lows, that’s a bullish signal. By the same token, when stochastics are oversold above recent highs but the underlying isn’t rallying higher in price, it’s probably time to exit or go short. Candle formations and Moving Average behavior will confirm or dismiss this early signal most of the time. Let’s cover additional filters elsewhere but do research this divergence action yourself in the market of your choice. It’s a powerful indicator that works a majority of the time when confirmed. I hope this helps you sift out some good use of stochastics in your market analysis. Looking forward to our visit tomorrow! Watch for those turning points, Contact Support ********************** PLAY OF THE DAY - CALL ********************** EXDS - Exodus Communications $92.75 -3.63 Exodus provides Internet system and network management solutions for enterprises with mission-critical Internet operations. They have pioneered the Internet Data Center (IDC) market and is one of the leading providers of Internet server hosting to the growing number of companies using the Internet. At present, Exodus also has twenty Internet Data Centers where clients store their servers in secure vaults. Clients include CBS Sports, eBay, Lycos, Yahoo!, MSNBC, and Hewlett-Packard. Most Recent Write-Up The dynamic momentum that thrust EXDS upwards over the past couple weeks got a shot of adrenaline on Wednesday. Exodus announced that its shareholders approved an increase in authorized shares to 1.5 bln and confirmed a payable date of June 20th for a 2:1 stock split. This gives us just six more sessions to make our trades. If you want to open new positions there's light support at $92, then $90, but confirm a bounce with volume first. A break over the 50-dma ($91.59) is a bullish sign and may signal the start of a profitable split run. Once we see the upside of Friday's intraday high tackled ($98.75), then resistance lies at the sometimes illusive $100 level. Because life isn't always fair, we can't rule out the possibility of a pullback, so take precautions or be on the sidelines if EXDS dips under $90. A slide back to old resistance at $80 near the 10-dma ($81.28) isn't out of the question in an uncertain market. The next week, however, should fare well with Friday's economic data further indicating a benign outlook. So if all the stars move into alignment and the momentum continues to mount, you'll want to look for an exit no later than the split date. OIN never recommends holding over the event as the risk of a depression far outweighs the potential gains. Comments EXDS gave us the entry poiont we were looking for today as we would like to see another push in this split run. Most important, will be to confirm the market direction before entering this play. The Nasdaq is stuck in a tight range and could move in either direction. Support looks good around $88. BUY CALL JUL- 85 DUB-GQ OI= 730 at $13.50 SL=10.00 BUY CALL JUL- 90*DUB-GR OI= 930 at $11.25 SL= 8.75 BUY CALL JUL- 95 DUB-GS OI= 646 at $ 9.13 SL= 7.00 BUY CALL JUL-100 DUB-GT OI=1884 at $ 7.00 SL= 5.25 BUY CALL SEP-100 DUB-IT OI=1103 at $15.50 SL=12.25 Picked on May 28th at $62.00 P/E = N/A Change since picked +27.19 52-week high=$179.63 Analysts Ratings 22-9-0-0-0 52-week low =$ 17.75 Last earnings 03/00 est=-0.26 actual=-0.23 Next earnings 07-21 est=-0.24 versus=-0.14 Average Daily Volume = 7.92 mln /charts/charts.asp?sysmbol=EXDS *********** IN THE NEWS *********** When Is A Sale a Sale? By S.P. Brown There’s an old axiom in finance that says the higher the account is on the income statement, the harder it should be to manipulate. In other words, revenues should be less susceptible to accounting manipulation than net income because there are no accounts that drop into revenues like there are into net income. Of course, the operative word here is “should.” Many analysts are looking at revenues more closely, particularly in light which torpedoed the stock from a high of $333 March 10 to just $19 two months later. MicroStrategy’s problems began in late March when the company announced that it would have to revise its 1999 and 1998 revenues and operating results to conform to SAB 101, a Securities and Exchange Commission revenue recognition bulletin. The bulletin states sales shouldn't be recognized until product installation is complete and the company has a reasonable expectation of full payment. So, instead of reporting revenues of $205.3 billion for fiscal year 1999, MicroStrategy announced that figure would be restated to $155 million. Investors didn't respond kindly to the news. In a single day, the stock tanked from $226.75 to $86.75. Accounting for revenues seems simple enough. After all, isn’t selling a product just a matter of delivering the goods in exchange for cash or a receivable? If only it were that easy. Accounting, just like any other business practice, is open to interpretation. Here’s a simple example of a sales transaction, along with the number of ways the transaction can be accounted for. On January 1, a firm receives a purchase order from a customer for $20,000. The firm delivers $15,000 of the order in March and the remainder in April. Furthermore, the order is invoiced in April and paid in May. Now for the $20,000 question, how should revenue be recognized? The truth is, there is no hard and fast rule. One option might be for the firm to record the $20,000 revenue in the month the two extreme possibilities, with the former being the most liberal and the latter being the most conservative. A third option might be to record the $20,000 revenue when the order is invoiced in April, while a fourth option might be to record the revenue when the goods are delivered, $15,000 in March and $5,000 in April. However, the preferred recognition method would be to recognize the revenue when the goods are delivered in March and April. Since payment is not received until May, a receivable would then be established in March and April for $15,000 and $5,000, respectively. That was a relatively straightforward example; however, the art of revenue recognition can be a lot subtler. Looking at MicroStrategy again, the company was basically booking revenue upfront for sales of software packages that included a long-term servicing element. SAB 101 nixed that convention, so MicroStrategy was forced to restate revenues and recognize revenue during the length its contracts, instead of recognizing revenue immediately. Don’t think, though, that liberal accounting conventions are reserved for high-tech neophytes. Back in 1984, the personal computer boom was just starting to erode the role of Big Blue’s mighty mainframe business. IBM’s return-on-equity (ROE) hit 27 percent that year before plunging to 10 percent by 1989 and disappearing altogether in 1991 and 1992 amid huge losses. So what did Big Blue do, it headed for the accounting department. The company’s 1984 annual report showed that it began overhauling its accounting practices to spread the costs of its factories and other investments far into the future, instead of recording them in the short term. What’s more, the company took to recognizing its leases as “sales-type” leases, which enabled the company to record the entire life of the lease as revenues in the first year. In contrast, the more conventional operating lease method recognizes revenues as they actually flow each year. The convention worked for a while, but by early 1994, IBM’s stock was languishing at $20 a split adjusted share. By then, no accounting convention could conceal the company’s operational problems. Now, on the other side of the spectrum is Microsoft (MSFT), which is often accused of being too conservative in its accounting practices. The software giant has been criticized for excessive use of a liability account known as “deferred revenue.” This account is used to book revenues on which payment has been received but for which no product has yet been delivered. If used imprudently, the deferred revenue account can understate revenue and overstate liabilities. Okay, so when should a company recognize revenue? The Statement of Financial Accounting Concepts (SFAC) 5 specifies two conditions that must be met for revenue recognition to take place. These conditions are (1) completion of the earnings process and (2) its realization or assurance of realizability. To satisfy the first condition, the firm must have provided all, or virtually all, of the goods or services for which it is to be paid, and it must be possible to measure the total expected cost of providing the goods or services; that is, the seller has no significant contingent obligation. If, for example, the seller was obligated to provide future services but was unable to estimate the cost of doing so, this condition would not be met. As for the second condition, realization refers to quantifying the cash or assets to be received for product or services provided. Reliable measurement encompasses the realizability of the proceeds of sale. If the seller were unable to make a reasonable estimate of the probability of nonpayment, realization would not be assured, and the second condition would not be satisfied. Obviously, the SFAC 5 rule is open to wide interpretation, which means, in reality, an investor is dependent on management conservatism and integrity. Still, if you’re going to value a company based on revenue growth, it’s worth understanding how the company books revenue (that means reading the income statement footnotes), for nothing will trash a company’s stock faster than a forced restatement of prior-period financials. ************************Advertisement************************* Tired of waiting on trades to execute? Does your broker offer Stop Losses on Options? Trade instantly with Stop Losses at Preferred Capital Markets Stop Losses based on the option price or the stock price. Move your trading into the next millennium with Preferred Capital Anything else is too slow! http://www.PreferredTrade.com/CF/Home.CFM?ID=OIN ************************************************************** ******************* FREE TRIAL READERS ******************* If you like the results you have been receiving we would welcome you as a permanent subscriber. The monthly subscription price is 39.95. 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