And Suddenly Terrorism Is No Longer A Threat

By Duru

March 13, 2004


Merely one day after agitating over whether the global terrorist threat has suddenly expanded, the market launches a strong and spectacular rally. The natural conclusion is that the market has determined that threat is over, and we can all go back to our shopping. I have mentioned before that the market appears confused, and I will continue to harp on this theme. The market is suddenly waking up to risks that have ALWAYS been lingering. Terrorism is just one of them. We should expect further stomach-grinding action as the market finally decides to try to price in some of the risks to the great earnings numbers we have been getting from corporate America. However, the discounting for terrorist threats can be quite confounding. Below is a quote from on Friday, March 12, 2004:

"12:14 ET Quiet but jumpy trade in treasuries as players' set-up for potential weekend terrorism : Treasuries had clung to the lower levels of the recent range on profit taking and very light volume early, and then quietly rode the safe-haven trade back up. Traders have seen some action in the options, buying of April and May volatility ahead of the weekend, citing the possibility of additional terror news or activity. There has been a rumor circulating about a bombing in Turkey, but it was likely in reference to an incident earlier this week. The sentiment numbers were unimpressive as the labor situation continues to worry the public. The futures market has been skittish and thin, with a definite "bias to the buy side. It will be very difficult to go home short," offered one long-term dealer. Another agreed, adding "You have to be very afraid of the sell side ahead of this weekend, and if nothing happens, well, they dust this stuff on Sunday night." As security threats loom over the Euro-zone, cash is flooding into low risk, low yield currencies like the dollar, Swiss franc, Canadian dollar and Swedish krona leaving the euro and sterling down almost 2 cents a piece. The 10-year is currently -05/32nds; yielding 3.717%, 2-year is currently -01/32nds; yielding 1.478%, 5-year is currently -04/32nds; yielding 2.675%, 30-year is currently -05/32nds; yielding 4.675%."

From reading this, you would think that the bombing in Spain was our first confrontation with terrorist activity. Suddenly, traders are scrambling, perhaps even panicking, trying to account for the possibilities of weekend terrorist activity. What?!? So, perhaps the terrorists take a break this weekend and decide to enjoy the good weather. What happens after that? They will never return? As you can probably tell, I get particularly annoyed and peeved with this short-term logic. It makes little sense and again is the hallmark of a confused market that is under-going a transition that will only be clear to us once its over. My main point is that the terrorist threat has been with us for quite some time and will stay with us for quite some time more. Invading and taking over Iraq did not "solve" terrorism and probably made it even MORE of a threat. And the terrorists sure do not care about your investment portfolio and will not be killing and maiming according to some schedule. If nothing else, they are seeking to destabilize world financial markets - they are not interested in providing clues that allow easy discounting and prediction of their heinous crimes. So, it makes little sense for you to try to invest or trade around this threat in the short-term. If you care about the threat, then make it part of your investing thinking all the time. If you have hope and confidence in the future, then you should mainly ignore the market's immediate gyrations over these terrible moments and perhaps even think about buying into weakness.

Since the market is once again showing strong tendencies, I feel more comfortable having strong opinions on the market again. Friday's action is very reminiscent of past bear market action. In the middle of clear downtrends, we would get strong rallies that would help everyone temporarily forget about the real problems that are brewing. Make no mistake about it. The nature of the market has taken a clear and decided turn. The trouble has been brewing for a while, but only the NASDAQ and Dow Jones Transportation Index were clearly talking. With the S&P and Dow Jones Industrials joining the downward blues, we are compelled to sit up and take note. And do not be fooled by any logic that says that terrorists are bring the market down. It simply provided the latest excuse for sellers to cash in their chips. We must look more broadly and deeper to understand what is going on. For those of you interested in technical analysis, check out Martin Goldberg's convincing piece explaining the how and the why of the market's breakdown.

I will add to this expose, my own list of warning flags. See earlier missives to examine how my red flag notices have done. (I wish I had myself followed my indicators more faithfully!!!). As an intro, I will repeat my overall assessment that the market has put in some kind of top here. All rallies must be sold into resistance until proven otherwise. Dips may still be bought, but you must be prepared for further losses. Once the earnings numbers start faltering, you need to kiss this bull market goodbye.

1. I have called Intel's stock the flagship for tech stock health. It has failed miserably these past few weeks. And has experienced its worst breakdown since the bear market ended. It is now in very ugly territory and deeply entrenched in a downtrend having broken its 200 day moving average (price). This alone makes me extremely wary of tech's overall health.

2. I have before talked about Dow Theory. The Dow Transportation Index broke down in January suggesting that the Dow Industrials would be next. At the time I was not fully convinced because the Dow Industrials seemed to remain strong that I figured the Dow Industrials was the non-confirming signal for the decline of the Transports. I apologize on that one - even without hindsight I should have taken that warning signal a lot more seriously!

3. The Mcclellan Summation Index is a relative measure comparing advancing NYSE stocks against declining stocks. It dropped hard on Friday despite the huge rally. I take that as a non-confirming signal of a bottom and an indication that the market's momentum is fading.

4. The percentage of stocks that are above their 200 day moving average (price) has been in slow decline since mid-January. This does not mean that the rally is over, but it does suggest that the character of the market may be under-going change. This past week, this indicator moved downward more sharply than is usual, so I would expect a snapback like on Friday. I would definitely not ignore this signal.

5. The VIX measures the volatility in S&P 500 stock index. Volatility is a measure of sharply and frequently change is occurring. Market fear tends to drive this up, and market complacency tends to drive this index down. The VIX has been a tricky one of late. During the recent bear market rally, spikes in this index have been greeted with equally sharp buying as a counter-reaction to sudden "bargains" in the market. On Wednesday, The VIX made its largest spike in quite some time. In fact, a chart of the VIX suggests that this index is finally done going down as it has slowly and gradually done for a year. The quick buying we saw on Thursday then is not surprising, but the Madrid bombings upset the market's appetite to counter-rally, particularly as questions arose about who was actually responsible. Thus, we can view Friday's buying as a delayed reaction to the buying that should have held steadfast on Thursday. My warning here is that when an indicator does something different, particularly something it has not done in a very long time, it is time to consider whether something is changing or has already changed. Again, this makes me feel like the bias to the upside is OVER.

6. Finally, the utility index is the one major index that has stayed clean from its 50 day moving average (price) - that alone tells me how defensive the market has gotten! Utilities are typically an escape hatch for cash when the stock market begins to look less attractive. The sudden resumption in the decline of interest rates also makes the yields on utilities more attractive and their large debtloads easier to discount.

So, why am I throwing all this cold water at you? Am I saying the bear market is back? Far from it. I am giving you all this information because many people will cling to the past good economic and earnings news to suggest that all is fine and that we are seeing a "normal" correction. I suggest to you that a "normal" correction would not contain so many warning signs and instead would reveal what is often called a divergence. This divergence would feature a declining market in the face of improving technical indicators. Instead, we have a downward market confirming the declining technicals. You probably do not need to run for the hills yet, but you sure should not spend a lot of time hanging around in the valley either. And if you have been hiding out in the hills, stay put. Company is coming at some point, and they are going to need a lot of consolation…


Ó DrDuru, 2004