Option Investor

Daily Newsletter, Tuesday, 02/27/2007

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

China Syndrome

Every correction always seems to start when a news event occurs like a lightning bolt from a sunny sky. Just when everything looks the brightest the market gets zapped by an unexpected jolt. At least this is the perception by retail traders. Today's Asian contagion was reportedly due to the potential for government curbs on investment into the Chinese market. The words "capital controls" strike fear into the heart of investors. However, that potential has existed for the last month. Why did the global markets react today?

Dow Chart - Daily

Nasdaq Chart - Daily

There is always a scapegoat for every market implosion and today's drop was no different. The threat of governmental curbs in China was just the straw that broke the markets back. The constant commentary about an impending correction caused traders to tighten stop losses on every move higher and today those stops were hit. If you remember it had been almost 160 trading days since the Dow had a 2% decline and we normally get an average of eight -2% declines per year. They just don't normally occur in one day. This extremely long advance had simply produced some extreme overbought conditions and that makes the market ripe for a blowup. A series of unfortunate events combined to cause that blowup.

The crash started in China with a -9% drop in the Shanghai index. That sounds terrible but that same index just set a new high on Monday to close above 3,000 for the first time and was up +14% for just the last six sessions and +130% in 2006. The government said on Sunday it had setup a new task force to crack down on illegal securities trading but the market rallied to a new high on Monday. There was no concrete news on Tuesday but it was likely institutions just decided to take profits ahead of next week's congressional meeting and selling in an overextended market can be brutal. The drop was the largest for the index since 1997. According to one Chinese analyst many institutions were scrambling to lock in gains and some funds were selling to raise money for investor dividends due in March. With 140% gains over the last 12 months and 14% in the last six sessions you can imagine how frantic a sell off could get.

The selling was complicated by the extensive use of ETFs by global investors. Once a sell off begins the ETFs are dumped in massive quantities and that causes a corresponding wave in index selling as the ETF managers scramble to manage their offerings. An ETF market massacre has been predicted for years and the proliferation of emerging market ETFs over the last 24 months has made it even worse. Today could have been the first ever global ETF dump. Traders forget that when we buy or sell an ETF the ETF manager has to buy or sell the underlying stocks to reflect the open interest in the ETF.

It was not enough that China's meltdown was going global but the US got some very bad economic news as well. Durable Goods orders for January fell -7.8% following a rise of 2.8% in December. Core capital goods orders, -6%, have fallen in 3 of the last 4 months and today's drop was the sharpest since 2004. Without the drop of -18% in transportation orders the core orders still fell -3.1% and the sharpest drop since 2002. Adding to the problem was continued weakness in the Richmond Manufacturing Survey also reported today. The headline number came in at -10 and only slightly improved from the -11 in January. Order backlogs improved to -4 from -16 and new orders from -12 to -4 but business in the Richmond district is still very weak. With the ISM due out on Thursday investors feared some further bad news.

The subprime mortgage market took another hit and this one will be permanent. Freddie Mac (FRE) announced it would no longer be buying high-risk mortgages. Freddie is the major dumping ground for loan originators and buys the majority of mortgages in the United States. Freddie said they would require borrowers to qualify at the highest rate possible under the loan. For instance if an ARM started at 5% but carried an escalation ceiling of 10% during the life of the loan then the borrower would have to qualify as though it was a straight 10% loan. They also said they would no longer accept low documentation or no documentation loans, negative amortizations, balloon loans or interest only loans without significant new restrictions. They are also requesting that lenders collect escrow for borrowers taxes and insurance payments as is typical in prime loans. High-risk borrowers typically try to lower their monthly payments by negotiating to pay those expenses separately. By forcing lenders to escrow those additional payments on a monthly basis it forces borrowers to qualify at a higher level. The new rules are not going into force until September, which will give the housing sector one last selling frenzy for summer, but will severely crimp buying patterns in the fall. This could help push the US into a recession and another leg down for the housing sector. The Freddie Mac news sent financial stocks into an accelerated dive with Goldman Sachs leading the losers list with a -14 point drop.


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Just when you thought it was safe to retire the Greenspan punching bag the master of disaster returned to the limelight. It has been more than a year since Greenspan left his job at the Fed but he still packs a powerful punch. He spoke by satellite to a business conference in Hong Kong on Monday and warned that signs of an economic stall were increasing and the U.S. could fall into a recession by the end of 2007. His remarks panicked global investors starting in Hong Kong and some analysts think this was the real reason behind the market plunge in China. If the U.S. is heading for recession then demand for Asian products will fall sharply. While it may not have been the main reason in China it was definitely additional "Greasepan" for the skid. Add in the extremely sharp drop in Durable Goods orders today and it was the one-two punch for the U.S. market.

The prospect of a global cooling sent commodity and metals stocks into a sharp decline. Slowing economies use less raw materials and that leads to oversupply and falling prices at current production levels. Stock examples include RTP -15, RIO -4, BHP -3.29, PCU -5, ATI -8, TIE -3, RTI -6.39, IPS -5.40, X -7.39 and PD -4.57. The Asian oil stocks, up very strongly over the past year were knocked for huge losses with PetroChina (PTR) losing -7.53, Sinopec (SNP) -6.40, CNOOC (CEO) -4.63. The damage was not limited to Asian oils with Petrobras falling -7 but that was helped by a new announcement that Chavez was going to nationalize the last batch of oil fields in Venezuela.

It was not really a day for news about individual stocks but a day where the markets made the news. The internals were more negative than I or anyone else reporting the news could remember. The table below shows a selling imbalance that is unbelievable to most market observers. The imbalance on the S&P-500 was almost 100%. Only two S&P stocks closed positive for the day. However, the most startling numbers come from the volume. The up volume for the various indexes was measured in MILLIONS of shares while the down volume was measured in the BILLIONS. These are not misprints. For the entire S&P-500 there were only 15.8 million shares of up volume and 3.337 billion shares of declining volume. This is unheard of in modern time. The total market volume of 8.3 billion shares was also a record with 8.1 billion shares of that on the downside.

Market Internals

The volume was so heavy that the Dow Jones could not keep up in its calculations for the major index values. Just before 3:PM the exchange realized there was a problem and the Dow calculation was way behind reality. They switched to a backup system and that resulted in an immediate restatement of the Dow from about -260 down to an instantaneous level of about -460 down. This was a -200 point change in an instant. This sudden plunge appeared on the surface to be a massive bout of program selling when in reality is was simply the backup system kicking in with the true index values. When the new numbers suddenly hit the wires it prompted another round of selling from those who felt the bottom was falling out of the market. The broadcasters were breathless in their reporting and dazed by the sudden worsening of the situation. In reality that situation had been there all along and was simply being reported wrong due to the extremely heavy volume overloading the system. Stocks on the Dow Jones had to be closed manually due to the glitches in the system caused by the record volume.

Dow TICK Chart

This was the first major sell off in the markets since the NYSE went electronic. In the past the market makers had to stand up and take the trades and provide a "market" based on supply and demand and often that required them to buy stocks for their own account to maintain an orderly market. Now that the NYSE has gone electronic like the Nasdaq and others those trades are matched electronically and nobody takes the middle ground to provide a stable market. This could have further accentuated the decline and further overloaded the NYSE computer systems.

Once the news about the computer glitch started to filter out there was a sizeable rebound from Dow 12100 to 12300 but that rebound was short lived given the limited distribution of the news. The rebound gave stunned holders a new opportunity to unload at what they thought was a second chance offering. The Dow remained under pressure with a decline back to 12236 at the close. The Dow has lost more than 400 points only six times in history. The last time it lost more than 416 points was the day the market opened after 9/11 when it fell -684 points. During the crash in 1987 the Dow lost -508 points in one day but that equated to a -22% drop compared to today's 3.3% drop.

The only positive news was the sharp spike in chances for a Fed rate cut. Last week the chance of rate cut over the next three meetings was less than 5%. Today that chance spiked to a 58% chance of a cut by July. It was 100% intraday but eased into the close. The Greenspan recession comments, the Freddie Mac loan restrictions, the drop in Durable Goods Orders and continued weakness in the regional Fed surveys is going to trump inflation fears at the present rate.

The economic calendar has two major reports due out this week with the GDP on Wednesday and the ISM on Thursday. These will take on new importance but the real focus of attention will be on the market itself.

True bull market corrections are normally short, sharp and ugly. This one definitely qualifies today as sharp and ugly. It does not yet qualify as short. When the Shanghai market closed there were more than 250 stocks lock limit down. No more trading, done for the day, come back tomorrow. The odds are very good China will continue down at the open on Wednesday. As of 8:30 ET tonight Japan's Nikkei had dropped -584 points at the Wednesday open with South Korea's Kospi Index down -3.93%, Australia ASX down -3.06% and New Zealand off -2.68%. These are catch up events not necessarily further problems.

This still suggests there will be further selling tomorrow. Most US fund managers have never been though a true market implosion and there is some worry that they will conference tonight with their risk managers and realize that they have more risk than they can bear and take another level of investment off the table. As long as the bull was alive those managers could justify being fully invested. Once the bull stumbles they start to question that stance and risk managers at those funds will be advising a cautionary rebalance. A sharp drop as we saw today shocks risk managers back into the reality of a possible larger drop and normally produces further caution.

On a technical basis the Dow dip to 12086 intraday was a retracement to major support dating back to November. That erased all the gains since Thanksgiving. This 12000-12100 range is very strong support and I simply do not see it breaking under the current scenario. The rebound took us back to 12216 and that gives the Dow a 200-point cushion for any further dips. On a technical basis I would buy any further dip with Dow 12000 as your stop loss. This could be the mother of all buying opportunities but we need to approach it with caution.

The Nasdaq plunged more than 100 points at its lows and to hit major support at 2400. MAJOR SUPPORT! I would be a buyer at 2400 but be fully aware that should 2400 break it would be a major sell signal. The two-day dip this week knocked -125 points off the Nasdaq and nothing has really changed for the tech outlook in the last two days. Again, buy any dips to 2400 but run for cover if 2400 breaks.

The S&P-500 dropped -50 points, over 60 points intraday, to 1390. Very strong support at 1385 remains untouched. This is very strong support and without any specific news to the contrary I believe the China news is an anomaly and while their index may remain highly volatile for the next few weeks the U.S. indexes should shake it off and bulls reappear.

S&P-500 Chart - Daily

Dow Transports Chart - Daily

The only question is when will that occur. It depends on the Asian indexes tonight and especially on the Shanghai Index. The other Asian indexes will have to play catch up at the open but the Shanghai index will be the major directional force. Remember, the -250 point 3:PM dip on the Dow was a mechanical reporting problem. The index was really down that much but traders did not have the opportunity to acclimatize to the decline as it happened. Everyone thought it was just a -250 point day not -540. There are lots of decisions that occur over the couple hour period in a decline of that magnitude that were not made because the decline was not known. Had the index value been reported correctly while it happened it is doubtful we would have reached those levels.

The one flaw in my buy the dip scenario is the lack of any rebound in the futures in late trading. The Russell futures, my sentiment indicator, have yet to rebound from their closing levels. The S&P futures are up only +1.50 and that is negligible given the depth of the decline. I believe investors are waiting for Asian market news and will react when it is received. 2:AM Eastern Time will be the key for the futures. How the futures react will be the key to our open and the key to investor sentiment for Wednesday. With the S&P at 1400 and Nasdaq 2400 I will buy this dip immediately if any positive signs appear. Let somebody else bet on the bottom. I only want to follow on their coattails if they are right.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Apache - APA - close: 68.91 chg: -1.89 stop: 67.95

Oil stocks took a beating like most of the market on Tuesday but shares of APA managed to recoup some of its losses and close with a 2.6% decline. The OIX oil index slipped 3.4% versus a 3.29% decline in the DJIA and a 3.47% decline in the S&P 500. Shares of APA dipped toward short-term support near $68.00 before bouncing. A rebound from here could be used as a new bullish entry point but we'd probably wait for a new rally past the $70.00 mark before considering new call positions. Overall the action in the markets today was very bearish and more conservative traders may just want to exit early! Our target is the $74.50-75.00 range.

Picked on February 22 at $ 70.40
Change since picked: - 1.49
Earnings Date 05/03/07 (unconfirmed)
Average Daily Volume = 3.3 million


Diageo - DEO - close: 79.71 change: -2.31 stop: 78.95 *new*

Weakness in equities was global on Tuesday and DEO was no exception. The stock lost 2.8% and broke down under what should have been support at the $80 level. Yet shares managed to hold on to support at its rising 50-dma. More conservative traders may want to just bail out right away. We are raising our stop loss to $78.95. Our short-term target is the $84.75-85.00 range although more aggressive traders may want to aim higher. FYI: The P&F chart points to an $89 target.

Picked on February 14 at $ 81.04
Change since picked: - 1.33
Earnings Date 02/15/07 (confirmed)
Average Daily Volume = 452 thousand

Put Updates

MarineMax - HZO - close: 22.54 change: -0.23 stop: 24.05

If HZO is not going to decline when the rest of the world is in sell-off mode then bears may be in trouble. The stock lost 1% but spent most of the day trading sideways. We are not suggesting new positions at this time until HZO breaks down under the $22.00 level. The P&F chart continues to point to a $2.00 target. Our target is the $20.25-20.00 range.

Picked on February 11 at $ 22.59
Change since picked: - 0.05
Earnings Date 04/26/07 (unconfirmed)
Average Daily Volume = 300 thousand


Meritage - MTH - close: 38.88 change: -1.47 stop: 42.55*new*

The homebuilders lost 3.5% and shares of MTH under performed its peers with a 3.6% decline and a breakdown under support at the $40.00 level. Shares are nearing our target in the $37.50-37.00 range. We are adjusting the stop loss to $42.55.

Picked on February 11 at $ 41.99
Change since picked: - 3.11
Earnings Date 04/25/07 (unconfirmed)
Average Daily Volume = 473 thousand

Strangle Updates


Dropped Calls

Boeing - BA - close: 87.20 change: -1.73 stop: 87.99

Shares of BA lost another 1.9% and continued a sell-off that actually began last week. We were on the sidelines waiting for a breakout above the $92 level with a suggested trigger to buy calls at $92.51, which has not yet been hit. Given today's breakdown we're dropping BA as a bullish candidate.

Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/02/07 (unconfirmed)
Average Daily Volume = 3.9 million


Celgene - CELG - close: 53.17 change: -4.05 stop: 53.85

The sell-off in the markets on Tuesday hit the BTK biotech index for a 3.6% loss. This breakdown from the BTK's consolidation pattern could be the beginning of a larger correction but the BTK managed a minor bounce from old support near 740. Meanwhile shares of CELG really under performed its peers and shares collapsed with a 7% sell-off on big volume. The stock plunged through multiple levels of support before finally coming to a rest near support in the $53 region. We would have been stopped out at $53.85.

Picked on February 25 at $ 56.28
Change since picked: - 3.11
Earnings Date 05/03/07 (unconfirmed)
Average Daily Volume = 3.5 million


Freeport McMoran - FCX - cls: 55.75 chg: -6.17 stop: 55.85

Shares of FCX were upgraded this morning but it had no affect on the stock price. The news that China was going to try and curb speculative buying was somehow interpreted as a potential slow down by the Chinese for commodities, including gold. This hit the gold stocks hard. The GOX gold index lost 7.1%. The XAU index lost 6.9%. Shares of FCX gapped open lower at $59.55 and then dropped to an intraday low of $55.25 before closing with a 9.9% decline. We would have been stopped out at $55.85.

Picked on February 22 at $ 59.25
Change since picked: - 3.50
Earnings Date 04/17/07 (unconfirmed)
Average Daily Volume = 6.5 million


Chinese iShares - FXI - close: 95.00 chg: -10.40 stop: 103.99

The global weakness began in the Chinese markets after the government announced plans to curb speculative buying. The Chinese market closed down 8.8% and this was reflected in the FXI traded in New York. The Chinese ishares ETF gapped open lower at $100.21 and then plunged to an intraday low of $92.55. Our stop loss was at $103.99 so we would have been stopped out at the open.

Picked on February 18 at $106.90
Change since picked: -11.90
Earnings Date 00/00/00 (unconfirmed)
Average Daily Volume = 1.9 million


Ryder Sys. - R - close: 52.20 chg: -1.31 stop: 53.45

Monday's bearish reversal in R looks a lot worse now with a 2.4% decline and a breakdown under the 200-dma on big volume. We were waiting for a breakout over $55.50 with a trigger at $55.75. However, given the new weakness we're just going to drop R as a bullish candidate.

Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 05/04/07 (unconfirmed)
Average Daily Volume = 580 thousand


Research In Motion - RIMM - cls: 138.70 chg: -8.07 stop: 136.75

We have been stopped out of RIMM at $136.75, which is our new stop loss from Monday's update. Big weakness in the NASDAQ weighed on RIMM, which lost 5.49% after breaking out to new highs on Monday. If the markets rebound a new rally past $142.50 might be a new entry point.

Picked on February 20 at $140.51
Change since picked: + 6.26
Earnings Date 03/22/07 (unconfirmed)
Average Daily Volume = 9.1 million


Rio Tinto - RTP - cls: 215.13 chg: -15.47 stop: 216.99

RTP is another gold stock that got creamed today. Concerns that the Chinese might cut back on their demand for commodities sparked a huge sell-off in gold stocks. Shares of RTP gapped open lower at $220.83 and plunged to an intraday low of $214.45. Our stop loss was at $216.99.

Picked on February 14 at $221.15
Change since picked: - 6.02
Earnings Date 02/01/07 (confirmed)
Average Daily Volume = 437 thousand


Sealed Air - SEE - close: 64.37 chg: -2.01 stop: 64.84

We have been stopped out of SEE at $64.84. The market-wide sell-off sparked a 3% pull back in SEE. Furthermore today's decline has produced a bearish sell signal with the breakdown under $65 and its 50-dma.

Picked on February 25 at $ 66.82
Change since picked: - 2.45
Earnings Date 05/02/07 (unconfirmed)
Average Daily Volume = 296 thousand


Sears Holding - SHLD - cls: 178.54 chg: -8.10 stop: 179.89

We have been stopped out of SHLD at $179.89. After hitting all-time highs just a few days ago SHLD was a big target for profit taking during today's carnage.

Picked on February 14 at $183.64
Change since picked: - 5.10
Earnings Date 03/15/07 (unconfirmed)
Average Daily Volume = 1.2 million

Dropped Puts


Dropped Strangles


Today's Newsletter Notes: Market Wrap by Jim Brown and all other plays and content by the Option Investor staff.


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