May 14, 2002
Quite a few things to review today -- the Arms Index, the rally of last
Wednesday (5/8), and the confirmation rally of Tuesday (5/14), as well
as some of the prior failed rallies.
As discussed on these pages on April 12 (?), the Arms Index 10 day
moving average signaled an impending bottom would be formed sometime over the next 22 trading days. That day turned out to be May 7, or the 17th day after the signal. (Those unfamiliar with the Arms Index, or Trin, should review the past few comments -- see links below)
The Arms Index continues its streak as the "leading edge of
capitulation" -- not necessarily the panic sell off we saw on the week
ending September 21st, 2001, but a capitulation of sorts nonetheless.
But, as discussed, its crucial to always have a method to test your
hypothesis, and a line in the sand that indicates where you admit
defeat and go back to the drawing boards.
Over the past few months, we have seen a number of bear market rallies,
which some were hoping to be crucial reversal rallies -- all but the
most recent failed to receive that key confirmation.
I've found Investor's Business Daily publisher William O'Neil's method
for determining whether a reversal rally is for real or not to be
valid: O'Neil & Co. look for a confirmation session four to nine trading days after the reversal session -- index gains of 1-2% on greater than
average volume.
After the April Arms Index signal, we patiently were watching all
ensuing rallies for a confirmation. Like so many prior bear market
bounces, the April 16th rally did not receive the decided confirm. This
put us back in a "Wait and Watch" mode, until the 22 day Arms window
closed.
The rally of last Wednesday (May 8th) felt quantitatively different
than the prior bounces -- it was broad, deep and powerful, and closed at the highs of the day. The tenor was unlike the previous bounce; It had an
altogether different vibe; You could practically feel the Money Flow as
the day progressed.
But one of my key tenets is that gut instinct or feel are no basis for
financial decision making, and so we waited for the next data point --
the confirmation rally.
Our patience was rewarded yesterday. Strong volume, good index gains,
an all around powerful move; It turns out to be even stronger when we look into the internals:
-Volume ended up moderately strong, 2.25B on Nasdaq, 1.4B on the NYSE;
-NDX, Dow & SPX all broke through their 20 day moving averages -- a
very bullish short term development.
One of the interesting aspects of yesterday's move was Worldcom (WCOM), which was punted from the S&P500 -- as I left for softball practice yesterday (3 for 4 with a triple and a run scored!), WCOM had traded over 630 million shares, accounting for 28% of the total Nasdaq volume. Some have suggested that this means volume was not that spectacular, but I must beg to differ: Someone has to move all those shares, and that meant desks all over town -- traders, index funds, etc. -- were preoccupied with this action. There are only so many fingers and
keyboards in the universe, and so if you back out the WCOM, you must
substitute what these players would have been trading. Trading volumes
were still substantial, even if you give up half of the WCOM.
If we are going to play what ifs, we must review the flip side of WCOM:
the up/down volume on the Nasdaq. A cursory look shows a ~15 to 7 up
versus down volume; Certainly not that impressive, until you back out
WCOM. Suddenly, up/down volume is 15 to 1! That's outrageous, and
means we saw a real sellers strike on the Nazz. Even if we back out
half of WCOM, that's still 5 to 1, which is nonetheless a solid day.
So where does that leave us? I am bullish due to our prior discussions
of the Arms Index, and this confirmation makes me aggressively so. I
still have my line in the sand (last Tuesday's lows), I would use any
future dips to accumulate stocks down to that point -- stuff which will
benefit from the (coming) economic recovery: Longer term, I like
AOL below 20, CD From 17 - to 19. I continue to add to my existing
position in Key Bank (KEY), and RX. On the trading side, I like what I
hear about the upcoming cancer conference from Millennium
Pharmeceuticals (MLNM) -- I'm long between 16 -18; Activision (ATVI) is
a holding which might have legs -- The office is long as high as 32.50
and as low as 29.20. I also find BE Aerospace (BEAV) somewhat
intriguing between 11 - 13 as a very speculative play. Lastly, I am full up with Oils (P, XOM, RDC, HAL) as economic improvement will increase demand, and the impending Iraqi invasion May cause a spike in prices, and the Israeli/Palestinian issue does not have any simple solutions. Of
course, I get paid dividends to be patient.
Two final thoughts: This past weekend (5/11), Barron's cover story observed that the tech had finally come down, and the small caps had rallied to the point where the market was at last "rational." This was and is utter nonsense. The market is no more rational than the frenzied herd which is moving it -- which is to say, not very. Perhaps for a nanosecond, there is a moment of lucid rationality as it careens from deeply pessimistic and oversold to wildly optimistic and overbought. "Rationality" is a mere point in space that the market accidentally passes through as it oscillates from one extreme to the next.
Secondly,I would not expect this to be a rally like last September's
panic bottom and recovery. The process has been more gradual, the
valuation issues are still there (at least short term, an upcoming
article will look at how valuations can suddenly get cheap as stock
prices rise), and the economic backdrop, while improving, is still
somewhat tentative.
I would hope that our confirmation rally, coming after a "W" formation
in the broader indices (Dow, Comp and S&P), is a less frenetic, and
therefore more sustainable set of gains. We now have higher lows,
higher highs, and a nice retest practically built in already. This means we
now buy the dips rather than sell the rallies. I would expect to see gains
of 20 - 30% across the indexes over the next 6-12 months. That could
put us into a new trading range, and if the economic recovery takes root,
the continuation of a new bull market dating to September 21st, 2001.
Recent commentary on the Arms Index:
Arms Index Again?", April 12, 2002
Yesterday's Rally, Today's Action, Tomorrow's Prediction?", April 17, 2002
Confirming the Thesis", April 22, 2002
Revisiting Arms/More on Thesis Confirmation", April 29, 2002
-Barry Ritholtz
May 14, 2002
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