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Earnings Warnings Plus "Triple Witching" Plus...

By Scott "The Strategist" Fullman
June 17, 2001

Investors appeared to be complacent during the first round of earnings warnings, dismissing concerns about disappointing corporate results in the belief that they would lead to better opportunities for the future. As more companies joined the club, concerns that the first half of 2001 would be worse-than-expected rose. The focus is now turning toward 3Q, with only a few weeks left in the current quarter. Rumors toward the later part of the week began to surface of more corporate warnings. The most notable was that Microsoft Corp. (NASDAQ - MSFT) would announce that their results would not meet expectations, followed by a "no comment" from the company, whichcaused buying to dry up in the software industry.

Now add on the "triple-witching" expiration of futures and options contracts, which occurred on this past Friday. A lack of investor interest allowed the major market benchmarks to be moved with greater ease as the direction toward lower prices was met with little resistance. As expiration approached, more corporate guests joined the party, helping to turn the internal market gauges lower.

An area of concern that keeps raising its ugly head from the investment tar pits is the shortage, or potential shortage, in the energy sector. Gasoline and crude oil prices rose last week due to concerns that Tropical Storm Allison was impacting the refinery operations of several suppliers in Texas. This also helped to push heating oil prices higher. Additionally, politicians in several western states kept their story alive in the media as the Federal Energy Regulatory Commission began to investigate price caps in some regions.

UTILITY WATCH

We have been monitoring the utility sector closely, since this group not only shows how utility stocks are doing, but has been a very reliable indicator for the bond market, stock market, and the economy. As the chart below illustrates, the PHLX Utility Index (UTY) has dropped sharply during the past few weeks and is now testing against the lower trend channel line. A confirmed violation of that line could be a negative forecast for the future. Implied volatility levels have risen as option premiums rose because perceived risk levels increased.

ARBS
Risk Arbitrageurs began to unwind positions from the General Electric (NYSE - GE) / Honeywell International (NYSE - HON) wannabe merger. This caused the implied volatility levels for the stocks and the market to rise.

IMPLIED VOLATILITY LEVELS

It has been several weeks since the major market benchmarks reached their recent highs. Since that time, the Dow Jones Industrial Average (DJIA) has lost 6.4%, the S&P 500 Index (SPX) has dropped 7.8%, and the NASDAQ Composite Index (COMPQ) has given up 12.9%. Concerns that risk levels have been rising only began to surface last week as implied volatility levels began to climb from their respective lows. As of Friday's close, the implied volatility level for the NASDAQ 100 Index (NDX) rose to 53% from a low of 44%.

Trader complacency has been well established during the recent movement. Speculation that the market would bounce quickly on a short-term basis was illustrated by the optimism of the put/call ratios. While volume has declined, the implications of the ratios for the S&P 100 Index (OEX), Dow Jones Industrial Average Index (DJX), and Mini-NASDAQ 100 Index (MNX) have been negative.

Low put/call ratio readings, combined with relatively low implied volatility levels, indicate that the level of concern has been low, if not anemic. This leads to the belief that the probability favors a lack of upside pressure following the unwinding of the quarterly expiration cycle.

PAST HISTORY

Anticipation is building for a summer rally for stock prices. Since the market usually moves ahead of the economy, and as expectations of an economic recovery toward the end of the year emerge in the minds of investors, the market should realize new capital inflows. Additionally, history has shown that the four or five business days that precede the Independence Day holiday are usually positive.

We note that while there are indications for a positive summer season, there are many uncertainties both domestically and abroad that could have a negative impact on earnings, money flows, and the markets.

Guarded optimism is suggested for new positions. During periods of low implied volatilities, the use of protective puts is suggested to hedge positions. When volatility levels are high, the use of the covered call writing, naked put writing, and covered combination strategies can be advantageous for writers. Electronic worksheets and strategy scanners are now available for most of these strategies in "the strategist" section of the Ivolatility.com website.