Recently, I compared Traders in this market to the characters in Samuel Beckett’s
"Waiting for Godot."
Unlike the fictional personae in Beckett's play, who wait in vain for Godot's arrival, savvy Traders have been patiently waiting for the inevitable pullback. Their fortitude was finally rewarded on Monday, as the Dow gave up 275 points (nearly 3%), while the Nasdaq shed 69 points – just shy of 4%. Tuesday followed suit, with the Dow down almost 150, and the Nasdaq losing over 30 points.
The question of the week -- maybe even of the year -- is this: Is this pullback the start of a full blown retest of the September 21st lows, or is it merely a partial retracement of the gains since that bottom?
The odds historically favor a retest of recent lows. Successfully assessing the prior floor shows that there is a strong appetite for stocks at specific prices. That serves as an "all clear" signal for buyers. The shift from a snappish "V" to a successful retest "W" is also widely seen by technicians as Bullish.
The present pullback, I suspect, may prove to be the exception to that rule. There are simply too many factors lined up against revisiting those post-attack lows for me to be overly bearish here:
Extreme Sentiment
When the Market bottomed on the September 21st, a host of psychological factors caused extreme sentiment readings – most notably investor panic. The entire country was in the throes of the initial shock of the terrorist attacks; The horrific imagery of the Twin Towers collapsing and the Pentagon burning were still too fresh.
There was also a sense of waiting for the “other shoe to drop;” Would there be another terrorist attack? What was the US military response going to be? Prior to 9/11, the Bush Administration had a somewhat bumbling and heavy handed image; There was legitimate concern that the crisis might be mishandled. People’s imaginations in the two weeks right after the attack turned out to be far worse than the reality.
Against this backdrop, we had the U.S. Markets not trade for 4 days – the longest period the markets had been closed since War World II. Professional baseball and football games were cancelled for the first time in half a century. That only added to the negative sentiment. Without a relief valve, selling pressure built up. By the time the markets finally opened on September 17th, an overwhelming wave of sellers -- greeted with small numbers of very reluctant buyers -- hit the indices hard.
Barring another external shock, those panic inducing factors are simply not present in the current environment.
Buy the Dip or Sell the Rallies?
During the heady days prior to April 2000, "Buy the Dip!" was the rallying cry of the Bulls. After the Bears took over, "Selling the Rallies" became the more successful approach. Whichever of these strategies is working reveals whether we are in a Bull or a Bear market.
The trading action on Thursday, October 25, is a prime example of that. That’s when the market made what’s know in technical parlance as a “key reversal day” (or a "Bullish Engulfing Pattern" for you Candlestick aficionados). That day, the indexes gapped significantly beneath the prior day's closing prices at the market's open – about 2%. The Dow opened down near 170 points; The Nasdaq was off nearly 50 points. As prices became more attractive, however, bargain hunters started to snap up stocks on the cheap. Slowly, the indices began to erase their losses. Despite a parade of negative economic news and anthrax scares, by mid afternoon, the red on trading room screens had turned to green. Once the indexes turned positive, there was no looking back; The Dow closed up over 150, the Nasdaq gained more than 50, and the S&P500's gain was 2.3%.
The reversal day is significant, for it strongly suggests a resurrection of the "Buy the Dip" mentality, long associated with Bull markets. The strong volume on the key reversal day also bodes well. Its notable that selloff on Monday and Tuesday was on lighter volume compared to the rally the prior few weeks. That tells me the supply of stock for sale is becoming exhausted -- yet another bullish sign. "We have a hard time believing that Monday's weakness on light volume was more significant than Thursday's positive intraday reversal on heavy volume," noted Jeff deGraaf, Lehman Brothers technical analyst.
Weak Openings, Strong Closings: This also manifests itself in the difference between the first hour of trading and the last. From the time the market closes at 4:00pm, until it opens the next morning at 9:30am, investors are treated to a torrent of negative news. Not only do we get the usual bad earnings and weak economic releases, but each night we're treated to updates on corporate layoffs, the war in Afghanistan, fresh Anthrax scares, and FBI warnings about imminent terrorist attacks.
It’s no wonder that passions rule the opening. That first hour of trading reflects all of that emotional baggage -- and usually to the downside.
Investors need to recognize that what's reported on the nightly news is what's already happened; The markets primary concern is what's going to happen. The difference can be seen in the "Smart Money Index." This quant tool compares the market's first hour of trading -- the emotional, news driven opening -- with the more contemplative, institutional driven action of the last hour of trading. Since March 2001, this broad indicator has been strengthening. That suggests a significant Bull market is in near future.
Historically Low Yields
Bond yields are now so low that almost any decent dividend stock is appealing versus treasuries. The short-term t-bill rate hit a new low of 2.12% last week. People buy high quality bonds for income (yield), not capital appreciation. Some blue chip stocks have dividend yields comparable to bonds today, but also have significant long term upside potential. That disparity causes capital to flow out of fixed income instruments and into equities.
The Fed is expected to cut rates yet again (likely a 1/4 point) next week, and one final time in December. As long rates continue to tumble, this rotation out of bonds and into stocks will accelerate.
Other Factors
Numerous other factors also oppose a more Bearish outlook. In addition to the Fed's Fiscal stimulus, a huge Economic stimulus package is coming out of Washington, DC. Commodity prices continue to trend lower; Raw materials, most especially energy prices, keep drifting down. The CRB index is now on the verge of breaking into its lowest level since the mid 1960’s. Even the IPO market is showing signs of life.
All these factors should boost economic growth by the middle of next year.
The Calendar is also helping. October is always a challenging month -- and not just because of the ghosts of prior crashes. Mutual funds are on a fiscal year that ends October 31st. Whatever tax selling these institutions need to do -- selling which pressures stock prices -- will be finished by November 1st. Add to that the end of the earnings season, and we might even have the makings of a Santa Claus rally.
As the country acclimates itself to a wartime environment, consumer spending may actually start to rebound. A certain "Lets enjoy it while we can" attitude would not be a surprise. I'm aware of the limits of anecdotal evidence, but let me share this quick story. My wife (She's the one with the Common Sense in the family) recently surprised me. I had been badgering her about getting a boat all summer long. In her fiscally prudent manner, she outlined all reasons why a boat would be impractical: it cost too much, we couldn't afford it, maintenance and dockage are expensive. "A boat is a hole in the water where you throw away money." A few weeks after September 11, she stunned me by suggesting that, perhaps in the Spring, we should look into getting one after all.
That "live for today" attitude, however short-lived, could become widespread in many consumers.
Lastly, let's not forget the massive amounts of cash on the sidelines. Several trillion dollars in cash shifted form equities to money market funds over the past 18 months. Those dollars will eventually work their way back into equities -- especially if money market accounts start failing to keep up with inflation.
All this works to change my view of how likely an all out retest is. Before last Thursday's reversal, the odds favored at least a 50% retracement. That would have brought the Dow as low as 8650, and the Nasdaq to 1500. Now, my numbers skew more towards a minor pullback in the 33-38% range. Combined with technical support levels, that places my downside targets on the Dow near 8950-9100; the Nasdaq should find support in the 1560 to 1660 range. The S&P should find support around 1050.
Since the "September 21st lows, we have had an uninterrupted move off the bottom. Gains between 20 - 29 percent – in less than a month – are simply unsustainable. But as long as buyers demonstrate the ability to fight off weakness, the market's message is that there is still latent buy demand which has not been satisfied. That is a positive for the long side of the market.
The Nasdaq has been particularly strong; The down side here looks washed out. As such, I strongly suggets closing your shorts on this index in most instances.
In this environment, even sideways action is bullish, as it exposes a lack of selling pressure. Take advantage of it.
Barry Ritholtz
October 30, 2001
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