Rolling the Dice with Cubes

05/06/2005 12:00 am EST


Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

"Wall Street is lulling investors to sleep with soothing words," warns Bernie Schaeffer , who believes this bullish consensus is misplaced. Here, he offers a technical, fundamental, and sentiment-based assessment of the market and a way to play expected weakness.

"We are being treated to nonsense from the usual Wall Street suspects such as ‘rising interest rates are OK as long as they are in small increments,’ ‘a little inflation is OK as long as it doesn't spike,’ ‘the economy can thrive with $60 oil,’ and ‘slowing earnings growth is OK because earnings are still growing.’ And, of course, there's that ‘soft patch’ expression used by pundits to describe a weakening economy, implying just a temporary respite in an environment of perpetual growth. Meanwhile, what is rarely heard is the fact that the Fed is handcuffed. It can't raise rates too aggressively to combat inflation due to our debt-laden economy and it can't reduce rates aggressively to stem a downturn, as rates are still very low.

"But my concerns about the market are not limited to an ugly economic picture and ‘slope of hope’ complacency that indicates very little sideline buying power. The technical underpinnings of the market have unraveled in 2005, as the weak price action has taken out major technical support levels. In addition, such previously ‘hot’ areas as small and mid-caps, emerging markets, and convertible securities have taken major hits this year. In addition, 2005 is the first year of the presidential term (which has been a poor one for the market historically) and we are moving into the ‘sell in May and go away’ negative seasonal period. I see the market as being vulnerable to a decline to the 8,000-8,500 level on the Dow Jones Industrials. I advise investors to reduce their exposure to the market and raise cash levels to 25-50%. Avoid the large-cap blue chips as well as the technology sector and concentrate investments in defensive sectors such as food, energy, and utilities. And perhaps most of all, ignore the lullabies from the professional optimists on Wall Street.

"How can options traders position themselves for this trend? We would buy puts on the NASDAQ 100 Trust (QQQQ NASDAQ), known as the 'cubes'. We have seen complacency on big-cap tech stocks despite their slide lower. Such complacency amid weak technical performance suggests vulnerability in the intermediate to long term. In addition, the number of QQQQ shares sold short continues to shrink and is fast approaching a new annual low. With a short-interest ratio of just 2.07, the ‘cubes’ will be hard pressed to find any kind of short-covering support. Meanwhile, the CBOE NASDAQ Volatility Index dropped back below key resistance at the 19 level, another sign of continued complacency. Digging deeper, we find that the big-cap tech sector is littered with technically weak stocks set against a sentiment backdrop of extreme optimism. In fact, several key players have earned a Schaeffer's Equity Scorecard ranking of 2.0 or less out of 10. Technically speaking, QQQQ has tumbled below key support at its 10-month and 20-month moving averages. For those aware of the risks of options, we would buy the QQQQ January 2007 40 put."

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