A Tale of Two Markets

04/02/2004 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer uses a unique blend of fundamental, technical and sentiment data to assess the markets. His latest such assessment leaves him bearish on blue chips and bullish on the small caps. Here's his analysis and suggestions to play these seemingly opposing trends.

"The Dow remains the 'headline number' that represents 'the market' to the tens of millions who have a casual interest in stocks. And the public's perception of stock-market conditions has been skewed positively in recent years by the abnormal relative strength in the Dow. The major contributing factors to this strength have, in my opinion, been heavy short interest and a major rally in the cyclical stocks that dominate this index. Heavy short interest provides the backdrop for sharp rallies due to urgent short covering. And nowhere has this been of greater importance than in the Dow Diamonds Trust (DIA ASE), an exchange traded fund keyed to the Dow.

"The bottom line is not certainty that the market is about to fall apart here. But risk is abnormally high and there is a much greater-than-average chance of the market seriously weakening. The notion that 'safe stocks' will protect you from a weak market is nonsense. These are the same stocks that have been favored by the plodding (and serially underperforming) institutions, who will be the first to be trying to squeeze out the narrow exit door should the market drastically weaken.

"Over the past three years, the Dow has failed three times at the 10,700 area. Notably, the failures in 2001 and 2002 were followed by sharp declines in the Dow. What's more, the 2004 peak fell just shy of the 50% Fibonacci rally off the Dow's October bottom at 7197. Despite these warning signs, skepticism is waning, as DIA short interest declined from 28 million shares in mid-February to 20.75 million shares in mid-March. Should DIA short interest continue to decline, it will have increasingly bearish implications for the Dow. For options investors, we recommend buying the Dow Diamonds January 2005 108 put."

"At the same time that I am cautious on the Dow, I'll make the case for holding a decent portion of your invested assets in the small-cap arena, as exemplified by the Russell 2000 Index, which we would play via the  iShares Russell 2000 (IWM ASE), an exchange traded fund that tracks the broad-based small cap Russell index. We spend a great deal of time reviewing the financial media for clues about the general sentiment backdrop. For over a year, the chorus from Wall Street has been very consistent regarding small caps vs. large caps and it can be summarized: 'The small cap rally has been overdone. Switch to the safer large-cap names.'

"While the bullish case for small caps is fairly strong, it comes with the warning that this is a risky and dangerous market environment. Should the blue chips mount a serious decline, there will be no place to hide in the small caps (though I do believe they would hold up as well, if not better, than the big caps). But should the market stabilize and/or rally from here, I believe the small caps will continue to provide much higher relative gains. So small-cap exposure does make sense to me, assuming it's within the context of a portfolio heavy in cash."

"Meanwhile, pessimism continues to run rampant toward small-cap stocks. Options players have recently piled into IWM April puts at a faster rate than calls. Adding to the buildup of pessimistic sentiment, short interest soared 13% in March to 27.2 million shares. Not only is this a new multi-year high, but it would take more than four days to cover these bearish bets. This accumulation of short positions could easily fuel a covering rally. We're looking for an oversold bounce in the index, which could be supported by added buying as the shorts cover their bets. For options players, we recommend the iShares Russell 2000 Index August 113 call."

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