Option Investor

Daily Newsletter, Wednesday, 07/06/2005

Printer friendly version

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Dennis the Menace

Dennis the Menace

Energy prices surged higher on Wednesday with August Crude Oil futures (cl05q) settling up $1.69, or 2.84% at $61.28 as traders await the arrival of Tropical Storm Dennis. The latest measures from the U.S. National Hurricane Center in Miami have Dennis nearing the "hurricane" category, with current direction and speed reaching landfall near the Alabama-Florida border this weekend.

Energy companies operating in the Gulf of Mexico made announcements that non-essential personnel were being evacuated from operations in the eastern-Gulf of Mexico, while workers in the mid and western-Gulf were returning after Tropical Storm Cindy reached landfall yesterday.

Natural gas prices were also sharply higher with the August contract (ng05q) jumping more than 21 cents, or 2.85% to $7.688/mmBtu.

For August oil, the previous contract high of $60.95 was no match and thus far oil is up roughly 75% year-over-year and about 45%in 2005 alone. An active storm season should have traders looking more closely to tomorrow's Department of Energy report.

Volumes were brisk at both the NYSE and NASDAQ exchanges, and underpinning bids were hard to find especially with Challenger Gray & Christmas reporting layoffs at a 17-month high. The outplacement firm said corporate announcements of job reductions increased by 35% from May's 82,282 and 73% from June 2004's 64,343. The automotive sector announced 45,378 job cuts in June, while the retail sector cut 24,065 jobs.

In a separate report issued Wednesday, the Institute for Supply Management reported an unexpected jump in the nonmanufacturing sentiment index in June, indicating strong growth. 

The ISM index rose to 62.2% in June from 58.5% in May. June's reading was well ahead of expectations that had been anticipating a decline to 58.4%.

While energy prices rose sharply, it was energy-related sectors that suffered the wrath of sellers. 

After trading 52-week highs the past few sessions, the Utility Sector Index ($UTY.X) 419.81 -1.77% was today's sector loser, while the Natural Gas Index Index (XNG.X) 363.65 -1.42% finished down 5.27 points after hitting an intra-session all-time high earlier this morning.

U.S. Market Watch - 07/06/05 Close

The Morgan Stanley Healthcare Index (HMO.X) 1,598.08 +1.62% surged mid-session to trade an all-time high. The gains were sparked on news that UnitedHealth (UNH) $53.19 -0.07% would buy PacifiCare (PHS) $77.10 +6.08% in a cash/stock deal that values PHS at roughly $77 per share.

Already we're hearing that regulators are looking over the deal as the number of health insurers become fewer. The move would give Minnesota-based UnitedHealth a stronger presence in the growing Medicare market. It hasn't been as aggressive as other players in marketing that coverage. Further, the deal would combine two formidable individual and group-health entities, PacifiCare's AMZ and UnitedHealth's Golden Rule.

The Dow Industrials (INDU) closed near its lows of the session, its first triple digit loss since June 24 (the Dow lost 99.51 points on June 30). Of the blue chip barometer's 30 components, 28 contributed to today's losses. 

Dow Industrials (INDU) - 50-point box

Of the 5-most heavily PRICE weighted components, only IBM $75.81 +1.36% managed to post gains today. After giving a triple top buy signal at the 10,300 level on May 3, the INDU has shown a tendency to "stretch its wings" higher, then retrace those gains, and work itself to another relative high.

While 10,000 is also "psychologically round" support, it is also important technical support. 

I would note that the Dow Diamonds (AMEX:DIA) $102.67 -0.92% currently has a bullish vertical count of $133 associated with its point and figure chart, where a trade at $99.00 (9,900 INDU equivalent) would generate a reversing lower point and figure sell signal.

The very narrow DJIA Bullish % ($BPINDU) from www.stockcharts.com currently reads "bear correction" status at 66.66%, is in a column of X and would need to achieve a higher reading of 74% to reach "bull confirmed" status. It would take a reversing lower measure of 60% for this bullish % to turn back lower to "bear confirmed" status. In late April (red 4), this very narrow (measures just 30 point and figure charts) reversed up from 50%.

Dow component Alcoa Inc. (AA) $26.00 -0.76% begins the parade of second-quarter earnings announcements for major U.S. companies on Thursday, reporting results after the market closes. Many analysts have cut their forecasts for the aluminum giant, whose stock is a Dow component, in recent weeks as aluminum prices have fallen. The average estimate stands at 45 cents a share on sales of $6.64 billion, according to a survey by Thomson First Call. A year ago, the company posted profits of 46 cents a share. Yesterday, CS First Boston lowered its earnings estimate to 42 cents a share from 54 cents, citing lower than expected aluminum prices and pointing toward "operating challenges" at Alcoa's Russian operations. The company's earnings are "very sensitive" to aluminum ingot prices, which have so far averaged 76.5 cents per pound in July, down from a June average of 78.3 cents. 

When the quarter ended last Thursday, the estimated earnings growth rate for companies in the S&P 500 Index stood at 7.4%, according to consensus data from Thomson Financial. That's the lowest pre-report estimate since the second period of 2003, when S&P 500 firms were expected to report earnings growth of 7%. 

Results have outpaced pre-report estimates in every period since the fourth quarter of 2002, according to Thomson data. For the first quarter, earnings grew at an actual rate of 13.9% -- far ahead of the 7.6% growth rate predicted at the beginning of the period. Looked at another way, though, it's clear that earnings growth is slowing. Last quarter's final growth rate was 29% lower than in the previous period and the lowest since the second quarter of 2003, when S&P 500 earnings grew 9.5%. For the S&P 500 group, more than 60% of the pre-announcements for the second quarter have been negative, according to Thomson data. That makes for a negative-to-positive ratio of 2.6 to 1 -- the highest in eight quarters.

S&P 500 Index (SPX.X) - 5 & 10-point box

It may seem like a 5-point and even a 10-point box scale of the S&P 500 Index (SPX.X) is just "too big" to trade from, but with the SPX gyrating 7 to 10-points on any given trading day, this conventional box scale is filtering out the day-to-day noise. No, 7 to 10-points is just what a futures trader likes to see, but cash traders will see the SPX has been little budged since early June (red 6).

Today's action saw the broader S&P 500 Bullish % ($BPSPX) from www.stockcharts.com remain unchanged at 65.00%. Compared to last Wednesday's reading of 64.4%, we've seen a net gain of 3 stocks generating a reversing higher point and figure buy signal. On June 21, the S&P 500 Bullish % ($BPSPX) reached a near-term high reading of 66.40%.

One technique I'll use from time-to-time is to change up my box scale to a "less conventional" box size in order to get a different perspective of supply (O) and demand (X), and try to uncover where a key level of support/resistance is at. 

Here's a 3-box scale of the SPX. It adds more "noise" to the supply/demand chart, but I think it ties in nicely with last night's Market Wrap and work Jim Brown did for the SPX.

S&P 500 Index (SPX.X) - 3-point box

Now Jim didn't outline the little "head and shoulder top", but strength above 1,209.00 on the above 3-box chart is the likely level where bears would have stops. The neckline of this pattern would be 1,188-ish.

Now, I also show the 1,220 level from Jim's bar chart. That's a much BIGGER head/shoulder top pattern that is still "in play." 

Not everyone reading the evening commentary is able to "get a feel" for market psychology, but those of us that are will likely feel the "squeezing" of life from equities as oil prices rise. 

Today, stocks "felt" like they really wanted to bid, and while there are undoubtedly some shorts getting their heads handed to them in the energy futures markets, the push higher just sucked the life out of the major indices as the session wore on.

Be alert tomorrow. We may have simply seen some profit taking in energy EQUITIES today, but their weakness despite surging energy futures contracts has me suspecting that its the bullish momentum in energy futures that carries the trade there. 

Dow Transports (TRAN) - Daily Intervals

I didn't update the TRAN in last Wednesday's wrap, but the "Bear Stearns Trend" as I'm calling it continues to hold and is the trend I would have to consider as being the overriding trend. There aren't a lot of "profits to protect" as it relates to the way the TRAN is trading, and that may be the only reason it wasn't down more than 0.38% with energy prices rising.

A quick glance at Dorsey/Wright and Assoc. Transportation / Non Air Bullish % (BPTRAN) shows this group of point and figure charts still in "bear correction" status at 51.72% as of Tuesday evening. It would take a reversing lower reading of 44% to turn back lower to "bear confirmed." It would currently take an 80% reading to achieve "bull confirmed" status. 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
None None

New Calls

None today.

New Puts

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Chubb Corp - CB - close: 85.45 change: -1.18 stop: 83.49 *new*

CB is holding up relatively well during the market pull back today but we are concerned about the major averages. If the DJIA breaks down under the 10,250 level and/or if the S&P 500 breaks down under the 1190-1188 region then it could signal a new trend lower and CB will likely follow. We are not suggesting new bullish positions in CB at this time. We are going to raise our stop loss to $83.49, just under the simple 50-dma. 

Picked on June 10 at $ 85.05 
Change since picked: + 0.40
Earnings Date 07/26/05 (confirmed)
Average Daily Volume = 1.2 million 


Rockwell Collins - COL - close: 46.76 chg: -0.73 stop: 46.49 

Defense stocks were weak today along with most of the market and COL was no exception. Today's 1.5 percent decline under the $47.00 level and its 100-dma could spell very bad news for COL bulls here. We were almost stopped out today and if the broader averages show any weakness tomorrow we'd expect COL to hit our stop loss at $46.49 tomorrow. Conservative types may want to exit immediately.

Picked on June 27 at $ 46.75
Change since picked: + 0.01
Earnings Date 07/26/05 (unconfirmed)
Average Daily Volume = 800 thousand 


Cummins Inc - CMI - close: 74.76 change: -0.09 stop: 72.99 *new*

CMI is showing some relative strength today with a minor 9-cent decline. However, if the major indices keep declining we see CMI as a target for profit taking. The MACD indicator for CMI already looks poised to turn lower. The first level of defense is the simple 200-dma near $73.44 but we would not count on this holding if the SPX breaks the 1188 level. We are raising our stop loss to $72.99. 

Picked on June 19 at $ 74.03
Change since picked: + 0.73
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 970 thousand 


Coventry Hlth Care - CVH - cls: 73.33 chg: +0.49 stop: 68.99 *new*

News that UnitedHealth (UNH) was buying Pacifichealthcare (PHS) sent the health insurance sector higher. CVH hit an intraday high of $75.56 before pulling back. Looking at the intraday chart we see that traders bought the dip to the $72.00 level late this afternoon. This could be a new bullish entry point but we'd probably hesitate to open new long positions if the major indices are declining. We are raising the stop loss to $68.99.

Picked on July 05 at $ 72.75
Change since picked: + 0.58
Earnings Date 08/02/05 (unconfirmed)
Average Daily Volume = 1.0 million 


Fording Candn Coal - FDG - cls: 93.62 chg: +0.27 stop: 89.49 *new*

FDG appears to be in a no-man's land with the stock churning sideways in a narrow range. Readers might want to watch for a bounce from the $92.00 level as a new bullish entry point. We are raising the stop loss to $89.49. 

Picked on June 19 at $ 90.30
Change since picked: + 3.32
Earnings Date 07/25/05 (unconfirmed)
Average Daily Volume = 384 thousand 


Fortune Brands - FO - close: 90.53 chg: -1.45 stop: 86.95

Today's decline completely erased yesterday's gains. We do see that traders bought the dip to $90.00 late this afternoon. This could be a new bullish entry point but we would hesitate to open new positions if the major indices keep declining tomorrow. 

Picked on July 03 at $ 90.51
Change since picked: + 0.02
Earnings Date 07/22/05 (unconfirmed)
Average Daily Volume = 648 thousand 


Noble Energy - NBL - close: 78.13 chg: -0.72 stop: 73.99

Wednesday was somewhat of a volatile day for NBL. The stock tried to breakout over the $80 level but failed. Even the new high in crude oil could help push NBL higher with the rest of the market falling. We suspect that NBL could retrace back to the $76 level before moving higher. Be patient and watch for the bounce. 

Picked on July 05 at $ 78.15
Change since picked: - 0.02
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 1.0 million 


Quanex - NX - close: 54.39 change: -0.18 stop: 52.45

No change from our previous update. Our plan is to buy a breakout over resistance at the $55.00 level. Our suggested entry point is $55.10. Our target is the $59.50-60.00 range.

Picked on July xx at $ xx.xx <-- see Trigger
Change since picked: + 0.00
Earnings Date 08/25/05 (unconfirmed)
Average Daily Volume = 337 thousand 


Rio Tinto - RTP - close: 126.85 chg: +2.43 stop: 121.49 *new*

An upgrade to "buy" from Merrill Lynch helped launch RTP higher on Wednesday. The stock added 1.95 percent on above average volume. We do note that the rally did stall near its simple 100-dma. We probably wouldn't suggest new positions here as RTP may be tempted to fill this morning's gap before moving higher. Our target remains unchanged in the $129.50-130.00 range. We are raising our stop loss to $121.49. 

Picked on June 27 at $123.33
Change since picked: + 3.52
Earnings Date 08/03/05 (unconfirmed)
Average Daily Volume = 160 thousand 


SLM Corp - SLM - close: 49.47 change: -0.42 stop: 48.95

We are growing more concerned over SLM. Today's market decline didn't help and the stock is now testing its lows from last week. There is additional support at the 200-dma near $49.25 but if the DJIA breaks down under the 10,250 level or the S&P 500 trades under the 1188 level we would expect SLM to continue lower. 

Picked on June 20 at $ 50.92
Change since picked: - 1.45
Earnings Date 07/21/05 (confirmed)
Average Daily Volume = 1.8 million 


Sunoco Inc - SUN - close: 118.56 chg: -2.53 stop: 114.49 

Oil's new all-time high was not enough to protect the oil-related stocks from a sell-off with the rest of the market. SUN lost two percent and the lion's share of yesterday's gains. On a sour note today's session produced a bearish engulfing candlestick, which is normally seen as a bearish reversal pattern. We would expect a dip back toward the $118.00 level and maybe down to the $116 level before SUN turns higher. Watch for the rebound before initiating any new bullish positions. 

Picked on July 03 at $117.87
Change since picked: + 0.69
Earnings Date 07/21/05 (unconfirmed)
Average Daily Volume = 1.3 million 


Molson Coors - TAP - close: 60.31 chg: -0.66 stop: 59.49

We've been discussing a pull back to the $60.00 level and now TAP has provided one. Watch for a rebound from this level as a new bullish entry point. However, if the major averages keep declining we'd hesitate to open new plays. 

Picked on June 29 at $ 61.38
Change since picked: - 1.07
Earnings Date 07/28/05 (unconfirmed)
Average Daily Volume = 909 thousand 


Wellpoint Inc - WLP - close: 69.87 chg: -0.48 stop: 67.49 *new*

News of a merger between UNH and PHS sparked strength across the health insurer sector but WLP was unable to hold its gains. We are not suggesting new bullish plays here. Instead we're raising our stop loss to $67.49. 

Picked on June 05 at $ 68.40
Change since picked: + 1.47 
Earnings Date 07/27/05 (unconfirmed)
Average Daily Volume = 3.5 million

Put Updates

BodyAmbac Fincl. - ABK - close: 69.64 chg: -1.12 stop: 71.51

The market weakness today is good news for bears in ABK. The stock is back under round-number support/resistance at the $70.00 level. Shares also traded under the $69.65 mark where we have been suggesting new put positions. Our target is the $65.50-65.00 range.

Picked on June 26 at $ 69.62
Change since picked: + 0.02
Earnings Date 07/20/05 (unconfirmed)
Average Daily Volume = 992 thousand 


KLA-Tencor - KLAC - close: 44.91 chg: +0.54 stop: 45.76

It's time to go to red alert here! The semiconductor sector bucked the downtrend across the rest of the market and added more than one percent today. KLAC out performed its peers and added 1.2 percent to breakout back above its simple 200-dma. This could be bad news for bears like us. We do note that the rally did pause at minor resistance near $45.40. We're not suggesting new plays and more conservative traders may want to exit early. If KLAC reverses and trades back under $44.00 we might consider new positions then. 

Picked on June 29 at $ 43.88
Change since picked: + 1.03
Earnings Date 07/28/05 (unconfirmed)
Average Daily Volume = 5.4 million 

Dropped Calls


Dropped Puts

ESCO Tech. - ESE - close: 101.00 chg: -0.41 stop: 101.65 

Early strength on Wednesday morning sent ESE through our stop loss at $101.65 and closed the play. This was an aggressive, higher-risk play from the beginning. While we have been stopped out readers may want to keep an eye on it now that the major averages are starting to show weakness again.

Picked on June 26 at $ 97.80
Change since picked: + 3.20
Earnings Date 08/10/05 (unconfirmed)
Average Daily Volume = 102 thousand 

Trader's Corner

More on Dow Theory; Question on Volume


Some confusion over the last sentence in your 7/2 index trader article:

"The volume trend is still down, confirming the weak technical picture suggested by the fall below 37 when the trendline was pierced, making thechart picture decidedly bearish."

I thought increasing volume "confirmed" a move, in either direction, not declining volume?


I was speaking about On Balance Volume or OBV, an indicator invented to ferret out some important information from daily trading volumes. This indicator adds TOTAL volume in a plus direction on any day that the stock is up. Conversely, it deducts all daily trading volume on down days. The important thing is to look for direction. 

If declining, the OBV indicator is 'confirming' a declining trend, so to speak. If advancing; if the direction of the line is overall up, this line, this On Balance Volume (OBV) Indicator, is 'confirming an up move. The direction is up or down like price.

Whereas, as you say, volume, meaning daily trading volume will tend to INCREASE in the Direction of the trend. 

So volume can go UP to both 'confirm' an up or a down trend. The reverse is assumed to be true: volume will decrease in the OPPOSITE direction of the trend; e.g., tending to decrease on up days in a downtrend; tending to decrease on down days in an advancing or up trend. 


From here, my Trader's Corner topic is a carry over from last week. This prior article can be seen online at OI website: the 6/26 Newsletter.

I said then that what came to be known as Dow Theory became applicable or became principle tenets in the art (never 'science') of technical analysis. 

There was a lot more that Dow contributed to market knowledge and understanding than whether staying invested in the market was warranted or not. 

What follows are the basic tenets of Charles Dow along with my thoughts on it. I should also tip my hat to the contribution of Robert Edwards and John Magee, who wrote what many consider to be the 'bible' of technical analysis, Technical Analysis of Stock Trends, for their descriptions and analogy to the "tide, wave and ripple" effect, although this did not originate with them. 

Dow determined which stocks; the ones making up his averages, best represented the overall market. Every possible fact and factor relating to the price of a stock within the averages is quickly priced into the current traded price of that stock and hence into the averages. This is because the traded price reflects all knowledge that exists about the company and its current and future prospects in terms of its earnings power. Even so-called insider information will show up in the price and volume patterns that can be seen by astute observers of the trading in that stock. This group will in turn act on that information and that activity will become apparent to an ever-widening group. This principle is even truer today, given the extremely rapid and widespread distribution of information that occurs on the financial channels and on the Internet. 

CYCLES OF BULL AND BEAR MARKETS HAVE THE SAME REOCCURRING PHASES The point I emphasis here is that the phases of both bull and bear markets, while different depending on whether its a bull market or a bull market, are similar in terms of two factors:- elative knowledge about the market - Investor sentiment (attitude) about the market that ranges from disinterested to indifferent to interested; with varying degrees of intensity within disinterested and interested

A bull market comes after a lengthily and substantial decline in stock values that comes about due to a downturn in the economy or a recession. Major market advances are usually, but not always, divided into 3 phases. These phases are marked by who participates in them and what they are doing in each phase. 

In the first phase, there is accumulation or buying over a period of time, during which very knowledgeable investors with good foresight about a coming business upturn, are willing to start buying stocks offered by pessimistic sellers who want out. This group of investors will also start to pay higher prices as the willing sellers exit. The economy and business conditions are still often quite negative. The public, and this is mirrored by the financial press, is quite disinterested in the market, to the point of where owning stocks is very unattractive to them and they are out of the market. The people that got burned, so to speak, in the last bear market, are actively disgusted with the market. Sound familiar!? Market activity is modest at best but is picking up a bit on rallies, but this is mostly only noticed, if at all, by professional market participants. 

The second phase is one of a fairly steady advance, but one that is not dramatic. There is a pickup in business and encouraging economic reports as an improving economy leads to a pick up in corporate earnings. This phase is also a phase where money can be made relatively safely, as technical indicators turn positive and there tends to be an absence of volatile trading swings. 

The third phase, which at one and the same time can both be highly profitable and quite risky, is marked by heavy public interest and participation in the market. The economic news is good during this period and suddenly front pages of magazines have articles heralding the new bull market. The new issue market gets going as the public now has an appetite for new companies. This is the phase where you will hear banter at parties about the market, how well so and so is doing in stocks and where market-related Internet chat rooms are quite active. Price advances can be huge and volume matches. The more speculative stocks continue to advance but it is here that the blue chip stocks of the most established big-name companies start to lag. Some sharp downswings occur among stocks that fall out of favor. Speculation remains intense as seen in increased option activity, the first-day closes of hot new issues and in the level of buying stocks on margin. The end of this phase is always the same, varying degrees of collapse. This can come after a year or two or even after several years has passed from the beginning phase.

The animal analogy is quite apt, as the bear can both be very fierce and unforgiving, or can just go to sleep for a long period. Bear markets can usually also be divided into 3 phases. That this does not always occur is seen in the 1987 bear market that was sharp and steep, but with the decline only lasting two months. After that, there was a slow gradual process of advancing prices during which some bearish sentiment built up and people swore off the market. This phase didnt reach the typical bearish extremes however; as within 7-10 months the Dow had recovered nearly half of its October-November decline.

The first phase of a primary bear market tends to be a period of distribution. This really begins in the final phases of the bull market. It is the phase where selling begins by the type of experienced investors that didnt get overly swept up in the extremes in emotion and price at the bull market peak this group are the more investors with more foresight and a more balanced point of view. This group has the knowledge to understand that company profits have probably reached their peak and that the price multiples paid (P/E ratios) for those earnings are also at extreme levels. They began to sell or distribute stocks to the still eager and willing buyers. Volume of trading begins to slow. The public is still in the market heavily but may be a bit frustrated as the rate of increase slows down and not all stocks participate on rallies. 

The distribution phase is also one where people who are not usually in the market become buyers of stocks. A story that I used in my book (Essential Technical Analysis) is about a friend of mine who had always only invested in real estate. This person told me near the 2000 top that he had decided to buy some stocks, but had modest expectations he only expected or wanted to make 20% on his money. This kind of expectation for stocks that historically return 10% on average and had already been going up sharply for months, was the final thing that got me out of the market. 

I had noticed the froth in 2000 and that the volume was slipping and profits harder to come by. Then, my friends actions and comment became my shoe shine boy event referring to the famous story of Barnard Baruch, who one day got a stock tip from the fellow that shined his shoes. Baruch went and sold his holdings and said that when shoeshine boys are giving me stock tips, this was the time to sell. I was stuck by a similar occurrence in 2000 at Cantor Fitzgerald, where I was working in 2000, when I overheard one of our security guards on the telephone discussing his trading and going on about this and that stock in a very knowledgeable way like one of our floor traders. 

The distribution phase I already knew well, having been through two earlier ones before this last one. The first was in the silver and gold bull market and bubble of the mid to late-70s. In the final phase, I finally succumb to the siren call of this market and made an impulse buy of some precious metals. At least I can re-plate my silverware with the silver bars I bought. 

Then in the late summer of 86 I was the trader-manager of a stock index program at PaineWebber and had the sense to sell my positions on black Monday, but not the conviction to be short, where fortunes were made over a couple of days. (Actually the distribution phase had already completed itself by the preceding Friday and we were about to enter a panic.) The other side of my missed profit opportunity in not being short was that at least I was out - there were a lot of losses incurred, especially if investors panicked or traders had to sell to meet margin calls and didnt hang on for the ensuing weeks and months of recovery. 

Panic is a major characteristic of the second phase of a bear market. Buyers become scarce, bids falls sharply and sellers become desperate to get out. The downward acceleration becomes extreme and a near vertical drop can ensue at first, after March 2000 in the Nasdaq, the decline was gradually, occurring over weeks and months although there were some sharp down weeks, especially in the beginning. But then in 2002 as you know, it got pretty brutal as the market went into free fall this became very much the phase of discouragement which well look at next. 

The decline goes on longer when there is very strong conviction about the continuation of the bull market that has ended already the investing public, in general, does not believe the potential severity of the bear market or how they will eventually react to it. The handmaiden to fear, so speak, is hope. There is a reluctance to take a loss in stocks, especially a sizable one. Better to hope for a recovery. This is the phase where people will make a point of telling you that they are long-term investors. Investors have become conditioned to stocks going up and will maintain their faith in a market rebound for longer than is warranted by facts. Hope springs eternal as is said. 

After the initial part of the decline sometimes the worst part of the decline and often where prices are not dropping so steeply often comes the point where the economy has stabilized. Here, there can be a gradual market recovery and a rebound in prices of the stocks of the strongest companies. Or, this may be a long period where the market trends sideways. This is the third phase and is marked by discouraged sellers as the market does bounce back (more typical of BULL markets). There are many that didnt sell in the panic atmosphere that had prevailed earlier and give up on stocks the so called capitulation phase. 

Selling in the discouragement phase could also be coming from those investors and traders who bought during and after the steepest declines as they thought stocks looked cheap relative the inflated values of the late bull market stage. What causes this discouraged selling is that the rallies arent sustained and prices sink lower. Theres an old analogy about the erosion of a bear market being like a faucet dripping. Such slow steady loss, over time, becomes buckets. Business conditions at this stage may deteriorate further. Certainly there is an absence of good news with corporate earnings as the economy slides further. Sound familiar? 

The stocks that were very speculative, in terms of their potential to make money, may lose most of the rest of the their value in this phase. There were many Nasdaq stocks that have lost 80-90% of what they had gained in the prior bull market, in the 2 years after the March 2000 top. Blue chip type stocks tend to decline more slowly because investors hold on to them the longest. 

A bear market ends when all the possible bad news has been discounted. And it after it ends there is often even more negative news that keeps coming. Keep in mind that the discounting mechanism of stocks is always also an attempt to look ahead, so stock values will reflect the expectations of what earnings could be when business conditions improve for example, about six months ahead. It also should be noted that no two bear markets are exactly alike. The 1987 bear market was amazingly short in time duration and could be measured in weeks, although the price declines were quite severe. Some bear markets skip the panic stage and others end with it as in 1987. Bear markets go on for quite different time and price durations. 

Of 13 years with significant declines in the 40 years preceding the March 2000 March 2001 market drop, some have had steeper sell offs in percentage terms then what we have seen to date at least in the Dow. If we measure by the Nasdaq Composite, the 2000-2002 decline to date has brought a drop from closing weekly high to closing weekly low of 77% - 1987s loss of 37% seems minor compared to this.

The key aspect to knowing how it all works that however steep the price swings are, such as was seen in spectacular last phase of the tech bull market run up of 1998-2000 keeping in mind the characteristics of each phase will help you keep a level head. You know what is coming when the excess phase you are in ends and you can prepare for it. Keep in mind also, that these descriptions were made over 100 years ago. I have added more up to date examples, but the essential nature of the market phase stems from HUMAN nature and this is the constant or what doesnt change much. This relatively unchanged human nature, ours and others, is what you have to deal with in the stock market and it benefits us greatly when we can see which market phase we are in. 

OOPS - out of time. I'll make this a 3 part-er if you can stand it. Tune in this day next week.

Good Trading Success! 

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Contact Support with 'Leigh Stevens' in the Subject line. 

Today's Newsletter Notes: Market Wrap by Jeff Bailey, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.


Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.

To ensure you continue to receive email from Option Investor please add "support@optioninvestor.com"

Option Investor Inc
PO Box 630350
Littleton, CO 80163

E-Mail Format Newsletter Archives