The Week that Was

Several of you have written to ask whether this most recent leg down invalidates the Arms signal, and what this may mean for the markets over the next few months.

Let's begin with the generalities, and than move on to the specifics:

Amid signs of economic recovery and earnings improvements, the markets had their worst week since September 2001. Down 7.4% on the Nasdaq, the S&P down -4.4%, and nearly 400 points hacked off the Dow.

As this has been happening, several commentators have noted that they see too much bullishness.

I could not disagree more. In my observations, I am finding a general distaste for the capital markets; There is a broad and rampant fear of committing monies to equities.

This is beyond mere concern about stock prices. The integrity of the big brokers and their equity research have been brought into question; There's a disgust with the apparent corruption of fundamental analysts in particular (Merrill Lynch and Morgan Stanley are stand outs in this regard). A post-Enron crisis of confidence in key market structures continues, especially the accounting industry and the SEC. After developing expectations of fiscal surpluses into the next decade, the Feds have quickly fallen back into annual deficits measured in the 100s of billions of dollars. Add to that mix the heightened tensions in the Middle East, increasing crude oil prices, fear of interest rate increases, anxiety about terrorism, and a faltering economic recovery, which is on the feeble side. All the while, a continued war on terrorism is happening, albeit somewhat in the background.

Are these the ingredients which leads to excessive public bullishness? I think not.

Just as we saw an excess of bullishness at the top, we are now seeing too many people excited about being bearish near the bottom. Although I play the short side of the market on a regular basis, I'm less excited about shorting stocks already down 70, 80, even 90%; The low hanging fruit have already been picked. Even the perennially bearish William Fleckenstein --who's been oh-so-right about so many overvalued tech stocks, including IBM -- has disclosed that he is covering his shorts and waiting for less oversold conditions before he starts hitting bids again.

Revisiting the Arms Index

Several people have written to ask: Does this most recent leg down invalidates the Arms signal? The answer is "most certainly not."

The Arms index is a measure of "fear and panic" signal. Its more objective than a "gut instinct" because its mathematically based -- its uses a formula to determine when extreme levels of these emotions begin dominating the markets. But as noted in our previous Arms discussion, (http://www.oocities.org/ritholtz/rr/arms4.html Arms Index Again?), it is an early indicator, foretelling a "bottoming and rally anywhere from 1 to 20 trading days in advance" of the reversal.

So far, we are 10 trading days past that last Arms indication. We are at the midpoint of the "envelope" where a bottom should occur.

If we look at historical examples, we see a broad range of declines and time span from Trin signal to reversal.

Backtested analysis reveals some interesting data: In May of 1962, the Arms Index signal gave a 20 day notice, and preceded a 6.96% decline. The May 4, 1970 signal didn't see a bottom until after 16 days and a 11.67% decline. Two October surprises are particularly instructive: The October 16, 1987 gave one days notice -- and a 22.61% decline; A full decade later, the Trin signal on October 27, 1997 marked the exact bottom -- that very day, and that very price was the low. (Data courtesy of by Don Hays of Hays Financial Advisory).

As noted in the "Caveats" of the "Arms Index Again?" review (http://www.oocities.org/ritholtz/rr/arms4.html), the 20 day bottoming should "caution you into "scaling into new positions gradually over the next 3 weeks" as "a prudent approach."

Also noted in that piece was a cautionary note on the Nasdaq: it "may be oversold, and it could experience a strong move upwards." This is still true; as we said, "beware of the pricey and over-owned big cap techs as no more than a trade; Use the lift over the next 60 days to exit holdings you want or need to get out of. Longer term investors are still better off in the Energy, Health Care, Consumer Staples, Cyclicals, and Manufacturing Sectors for positions they want to hold on to."

Kevin Lane of http://www.technimentals.com/cgi-bin/mesh Technimentals observes that a "diversity of industry groups are performing well" in this market; The "concentrated Bear market is occurring in Tech and Telecom."

I still believe this is the case; To be bullish on the big cap tech stocks which dominate the Nasdaq COMP we need to see a resurgence in corporate capital spending (capex); That has yet to occur, despite the apparent economic recovery. Even firms reporting better than expected earnings are discussing Capex cuts, not increases. So I will reiterate the thought that these stocks are still not the best place to be -- stick with what is working and avoid what is not.

More on Confirming the Thesis

In our discussion (http://www.oocities.org/ritholtz/rr/thesis.html Confirming the Thesis), we addressed the issue of what would verify the April 16th rally day as being more than a one day wonder. I've had success using William O'Neill's confirmation session (an increase in the major indexes by 1 - 2% on greater than average volume on the 4th through 10th day after the initial up session) as an objective, unemotional guide.

We clearly did not get a confirmation of that 4/16 rally. So now we must fall back to our next target, and that would be the end of the Arms Index window, which closes on May 10th (20 trading days after the signal).

For the shorter term, we use technical levels of support to guide our estimates of where this decline could continue to. Note that these are not targets or predictions; rather, these are places on the indexes where there is support -- where buyers have materialized in the past. Its a truism that the shorter the time frame, the less reliable any market prediction is.

So rather than merely guessing where the markets will reverse from over the next 10 trading days, we shall look for areas where there is a higher probability of the indexes finding support. These are price points that could be used in conjunction with scaling into positions.

The downside DOW targets are 9832 (then 9740, and then possibly 9529), on the Nasdaq its 1620; If you're long, you'd like to see that level hold, cause after it is a straight whoosh down to the September lows -- not likely, but still theoretically possible. The SOX could see 500, while the SPX has support at 1050.

-Barry Ritholtz

April 28, 2002

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