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End of May... Go Away?

By Scott "The Strategist" Fullman
May 29. 2001

Stock prices began to correct the significant gains that they had registered during the previous few weeks as prices became over-extended on a short-term basis. Many of the benchmarks reached overbought levels following significant breakouts. Investors took some profits ahead of the Memorial Day three-day weekend, ahead of the earnings-warning season.

Some of the popular market benchmarks have registered impressive gains during the past two months. The Dow Jones Industrial Average (DJIA), the S&P 500 Index (SPX) and the S&P 100 Index (OEX) have produced patterns that are very similar to classic inverse head and shoulders, a pattern that is normally found near bottoms. A closing penetration of the neckline (see chart below) indicates the completion of this pattern and the start of a new upward trend. It is not uncommon for the neckline to be tested, since it usually becomes a new level of support. The profit taking that began last week has caused the levels of these major benchmarks to retreat back toward the neckline after reaching overbought levels.

Dow Jones Industrial Average (DJIA) - Daily Chart

Implied volatility levels for many of the benchmarks declined to readings that were in or near overbought. The rally that helped to lift the widely followed indices had produced higher levels of complacency and greater expectations despite declining bond valuations. Part of the reason that bonds have fallen appears to have been a shift from safety to growth. Nevertheless, investors and short-term traders became too enthusiastic over the rise in stock prices to care.

WHAT ABOUT NASDAQ?

While the performance of the NASDAQ Composite Index (COMPQ) has been impressive, a bottoming pattern continues to be forming similar to the one found for DJIA. However, the implied volatility levels for the NASDAQ 100 Index (NDX) and the Mini-NASDAQ 100 Index (MNX) both reached overbought levels for their respective indices. We have also noted neutral to negative put/call ratios for these two indices.

Higher quality NASDAQ issues have received the attention of investors versus lower quality issues, thus producing some divergences between COMPQ and NDX. We denote the difference between higher and lower quality issues based on whether company achieves profitability or not. There are many NASDAQ listed issues that are profitable as going concerns, but investors have been concerned with the firms that have not achieved profitable status and are likely to go out of business.

FED EASING DOES LITTLE FOR BONDS

Recent action by the Federal Open Market Committee (FOMC) to ease monetary policy has helped to raise consumer confidence levels, but has done little for the bond market. The yield on the 10-year T-note has risen from 4.77% in March to nearly 5.5% last month, which has resulted in a rise back to more than 7% for 30-year mortgages. Additionally, the implied higher rates have pushed the dollar up against the Euro, which has dropped to nearly 85 cents. This is not favorable for U.S. exporters and may impact the corporate earnings of international companies that have not hedged their currency exposure.

Alan Greenspan, Chairman of the Federal Reserve, stated that economic growth continues to remain weak and suggested that the Fed will continue its accommodative policies until growth returns. Mr. Greenspan also stated that inflationary pressures are not a major concern at this time.

IT's THAT TIME, AGAIN

As the final month of the second quarter begins focus will shift toward pre-announcements and warnings with respect to corporate earnings. Analysts will also adjust their quarterly and annual numbers based on comments from the companies that they follow. This could lead to a shift in both sector allocations and individual holdings. One result will be a movement in the implied volatility levels based on perceived risk factors associated with certain industry groups.

A popular market slogan, "In May go away," may not be beneficial on an mid- to long-term basis, but may be somewhat accurate on a short-term basis, given the lower volatility levels. Given the lower volatility and option premium levels, the purchase of protective puts against long stock positions may be prudent.

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