October 17, 2001
There is an old saw on Wall Street: you can predict either the direction of the Market, or the timing, but never both at once. I'm going to review several factors this morning, and make a bold (and likely futile) stab at both the timing and the direction over the next few weeks.
In 1956, the New York Times described Samuel Beckett's play, Waiting for Godot, as a "mystery wrapped in an enigma." The characters in the play wait futilely for Godot, who of course, never arrives.
The Market sometimes has that same "mystery wrapped in an enigma" feeling. Unlike Beckett's characters, we have some indicators to help us await what we know must be coming.
When the market crumbled on Friday, September 21st, we were fortunate to read these indicators correctly, and called that drop as the long awaited cathartic sell off. We started buying indexes and selective stocks that day, and caught equities at very advantageous prices. We are fortunate to have a good strategic market model and the nerve to buy when everyone else was selling. Of course, it never hurts to have a little good ole fashioned dumb luck.
Since then, we have somewhat impatiently awaited the inevitable retest, shifting the "V" bottom towards a "W" configuration. As stated before, we will aggressively be adding to our long positions if and when that pullback occurs.
But that normal retest has yet to occur. So we continually scan for clues as to what may be delaying it, while considering the possibility that our thesis is incorrect, and we are wrong: perhaps there will be no retest.
Four Factors Delaying Retracement
The "no retest" scenario" continues to be unlikely. We observe four factors which we believe are contributing to the postponement of this eventual retracement.
During the week of September 17th to the 21st, we had five straight down days in the market. The fifth day was our long awaited panic blow off -- a huge gap down, with lots of selling all day on extraordinary volume. That was followed by nearly 15 positive sessions.
At this point, one would expect a pullback any minute. In fact, too many people may be expecting that pullback, which is our first factor contributing to its delay. The Market has an uncanny way of confounding participants when they all mass on the same side of the boat.
That's merely one factor. Looking at the charts, we see overhead resistance a short distance from here. When stocks are bought high, and then are substantially "upsidedown," there is a natural tendency of people to say "If I can only get out at a break even, I'd gladly take it." That's a likely scenario, as we power shortly towards the levels where this supply of stock is strengthened by a downward sloping 50 day moving average. That convergence of supply and moving average is at roughly 9500 on the Dow, Nasdaq 1750, and S&P 1125. The market can be expected to initially bounce lower off these levels.
The weakening of momentum is our next piece of evidence. A self described "old timer" recently noted that Post Panic Bounces tend to run of momentum on their own after about four weeks.
This bit of homespun wisdom may be confirmed by looking at the overall market volume. As we have moved higher, we have done so on continuously declining volume. That indicates a rally starting to lose steam. A big upthrust on even weaker volume -- sometimes called an exhaustion gap -- could set the stage for the beginning of the retracement. Some of the positive earnings surprises we have seen so far this week -- in particular, Dow components J&J, Intel and IBM -- will cause a big pop when the market opens today. The volume will be the tell as to the internal strength or weakness of this next move.
Finally, and perhaps most intriguing, is the issue of shorts and this Friday's option expiration. There has been a rumor circulating the floor of the NYSE that a number of hedge funds pressed their short bets during the week of September 17th. They were waiting for the other shoe to drop, i.e., another successful terrorist attack.
Much of this shorting was done via options. Buying puts which may expire worthless this Friday presents the option holder with a 100% loss on that capital. Even worse are those daredevils who wrote naked calls. By doing this, the naked call writer sells to the buyer the right to buy a specific stock or index at a predetermined price. Come expiration day, those call buyers will demand their stock. Naked calls give the seller a theoretical infinite potential loss. Stocks can only go down to zero, but they can keep rising indefinitely.
This has caused quite a short squeeze, and has placed -- at least until after expiration day, a floor under the market. That may be the single most important factor delaying the retracement: Every dip is met with buyers covering their ill-advised short sales.
Bulls & Bears & Pigs
I find it utterly fascinating, and somewhat ironic, that we see the same behaviors at the bottom that we did at the top: successful strategies being blindly pushed too far. When the Nasdaq was closing in on 5100, and the momentum crowd had huge gains, few locked them in until after giving back enormous amounts of profits. Its the old adage: Bulls and Bears make money, but Pigs always get slaughtered.
Now, we see that very same behavior amongst those who had profited on the short side: The momo players keep pressing their bets, refusing to take huge gains off the table when they had them. Instead, they pressed, looking to capitalize on the tragedy of September 11th -- and have gotten crucified as the market powered higher.
Don't get me wrong, I am not morally condemning shorting after 9/11. You invest capital in the market to make money, and there is no valid reason to eliminate that motivation as legitimate after a terrorist attack. There is nothing unAmerican about shorting (though we discouraged it in our office that first week after).
What should be condemned is blindly following a (previously) successful strategy, regardless of the writing on the wall. At a certain point, not taking gains off the table becomes foolish. Pressing at that point is simply piggish. As we have noted, there is very little to gain from being a "perma" anything.
Final Thoughts
Has it really been over a month since the Towers went down?
It seems like much, much longer than that. My frame of reference is the usual cycles of the markets. Each month has an option expiration day; Just about every other month we have a Fed meeting. Every third month brings the end of a quarter, which includes the start of a new preannouncement and earnings season, a triple witching options expirations (when equities, futures and index options all expire at once), and of course, "window dressing," when funds mark up stocks the last days of the quarter so their performance appears better.
Yet here we are, five weeks after the attack, and it seems as if much more time has elapsed. Perhaps this "Time Dilation" is having a subtle impact on investor and consumer confidence. We will continue to finesse out what the impact of this time dilation may be on the upcoming economic recovery.
Had the horrific events of September 11 not occurred, it is very likely that both the markets and the economy would have started to recover. Let me share with you this thought from Jim Griffin, chief strategist at Aeltus Investment Management:
"Given everything else that has happened since Sept. 11, if it weren't for the psychological effects of those atrocities, the consensus likely would have shifted to a much more upbeat outlook for employment, output, revenues, earnings and, yes, even stock prices."
-Post-Traumatic Market Disorder.
I agree wholeheartedly with Jim. The market would have turned shortly, had the attack not occurred. But that unique and awful event impacted the pacing and the timing of this recent rally. It's also felt in the delay of the inevitable pullback -- which has been Godot like in its non-arrival.
We have experienced an accelerated fall, as well as a somewhat exaggerated snapback, due to these extraneous events. Eventually, we will move back towards a more "normal" market and economy. Until then, we are patient. We are not characters in a play, so we know the market -- unlike Godot -- eventually comes around . . .
Barry Ritholtz
October 17, 2001
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