Securities Research Services

Friday, June 09, 2006

Revisiting 2002

Prior to the open yesterday the outlook looked about as grim as it gets. We were very uncomfortable shorting against both a spiking volatility index (heightened investor fear) and a crowd that was so bearish that they were putting 4 times the amount of money into put options as they were calls. It is just not a good idea to run with the crowd when the crowd is leaning too hard in one direction. As a result we advised that sitting on your hands and not trading yesterday was the best alternative for all but the daytraders. This turned out to be good advice. After a panicky open we saw massive capitulation taking place as investors scrambled to exit their positions and as smart money grabbed up the shares. What is most notable were the market volume levels. The QQQQ had its all-time highest volume day yesterday as it traded an astounding 280 million shares; and this following a 234 million day two weeks ago, its highest volume number ever prior to yesterday. What does this mean? Well, there are some very strong similarities between volume and capitulation action which took place in July of 2002. Note that in July 2002 the VIX was spiking and the market was spiking downward into high volume reversal days. Following the low in July 2002 the market rallied sharply higher and then swooned into another late summer reversal. October of that year however marked a strong reversal that led to a two year rally. We remember this well because money was easy to make in the market during those two years and we made a lot of it. Why do we focus on July 2002 though? Why is it reasonable to expect a similar scenario to play out? Two reasons: First, the four year market cycle. Every four years the market tends to make a significant bottom as the market responds to lagging election year politics and other political and economic factors. More importantly though, four years ago marks the last time we witnessed such a large spike in volatility and market volume. Smart money is now making their bets and they are betting on upside, perhaps significant upside as early as this fall. Expect some nice roller coaster trading over the next few months. We should be able to make money on both the long and short sides as the market roils in a bottom-carving process. Expect yesterday's lows to be retested in the next week or two or three. Bears have not yet fully capitulated – but they will. Be flexible and be willing to switch sides quickly as the market whipsaws from week to week. This will be a fun ride if you ride with it and don't fight against it.

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