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Educational Article

Does History Repeat Itself\?

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We hit the 100-month moving average on Nasdaq on Wednesday, now what? We are in uncharted territory or are we? This bear market has been the worst decline in the Nasdaq since 1973. Currently, the Nasdaq has declined 68% as of Wednesday. The lows were put in on the S&P and the Dow on March 22nd. Since the highs back on March 31st, 2000, the S&P has declined 30% and the Dow has declined 21%, meeting the minimum definition of a bear market (20%). I think that's good news.

In the bear market of 1973, the Nasdaq declined 60%. Both the Dow and the S&P declined over 47% but this time they have only declined 21% and 30% respectively. Does this mean the S&P and the Dow have more downside?

The bear market of 1973 probably is the closest fit to the current situation. That decline lasted for almost two years. You have to dig a little deeper to unravel the mystery. From the bottoms in 1974 to the peak of the next bear market (8/87) the S&P & the Dow rose 400% and the Nasdaq rose 700%. From the bottom of the 1987 bear market to the peak in March last year, the S&P and the Dow rose 700% but the Nasdaq rose a whopping 1700%! Clearly, the Nasdaq was overvalued. Hindsight is wonderfully accurate. Looking at the ranges from lows to the highs in the previous two bear markets, it appears that the Dow over-corrected and the Nasdaq under-corrected, if you look at the percentages. So what does that mean? Let's look at the three charts.

Monthly Chart of Nasdaq:

Note my comments about finding support at the 100 period moving average in my article on March 18th. It appears that the Nasdaq is finding support at the 100 period moving average, which it also found back at the bottom of the 1987 bear market. It is too early to tell, but my bet is we are close to a bottom.

Monthly Chart of S&P:

Looking at the monthly S&P chart above you can see that the S&P moved too far and too fast, extending it way past the 100 MA. In fact, the S&P tracks almost perfectly with the 50 period MA. Every major and not so major correction went down and held around the 50 period moving average. The current price of the S&P is just below the 50 moving average.

Monthly Chart of Dow Jones:

Looking at the monthly chart of the Dow, the 50 period moving average provides a great historical fit. Notice how last month it dipped below and this month it is flirting with it. This is a great sign and it is finding strong support. Also a healthy sign is that the Dow corrected through time, in other words it drifted sideways until it caught up with the moving average.

All three major market averages are finding support at major moving averages (50 or 100), where they have found support in past bear markets. If history repeats itself, then we should be close to a bottom. However, before it's off to the races, history also shows us that we will go through a couple of real volatile months followed by some sideways action and they we can smile again for another 10 years.

So how do we play it? Volatility is much lower the farther out you go, especially in the QQQ's. The April implied volatility of the "at-the-money" calls is .74 versus the January '03 calls with an implied volatility of .52, which represents what is called a skew. What this means is that is a great time to be a buyer of long-term options or a seller of short-term options. Conversely, it is bad to be a buyer of short-term options or a seller of long-term options. Adjust your strategies according. A simple strategy that takes advantage of this skew would be a covered call, selling the April 40 calls and buying the stock or buying the Jan'03 40 calls. The April 40 calls have ranged in price from $0.40 to $2.25 in the last five days. Buy the LEAP and wait for the pop, then sell an out-of-the-money call against it. Remember, if an option has 9 months or more to expiration you only have to put up 75%. Not a bad way to go in these times of uncertainty.


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