Trading the NASDAQ Bust

By: Adam Hamilton | Fri, Feb 22, 2002
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Incredibly, as we rapidly approach the two-year anniversary of both the spectacular NASDAQ mania blow-off top of March 2000 and the ensuing brutal bear market in the once universally-loved index, the vast majority of investors still don't seem to comprehend what is transpiring before their very eyes.

While Wall Street shamelessly throws out innocuous sounding tripe like "normal inventory correction" or "mild recession" to placate the increasingly nervous mainstream investing masses, an extraordinary and exceedingly rare bust after a mega-bubble in the NASDAQ is relentlessly evolving.

Way back near the top in March 2000 the NASDAQ composite index commanded an enormous market-capitalization of $6,236b across 4,785 companies.  By December 2001 the NASDAQ's market capitalization had plummeted dramatically to only $2,817b comprised of 4,052 companies.  Long-suffering NASDAQ investors, as a pathetic group, had lost an astounding $3,419b or 55% of their total NASDAQ wealth by the end of 2001!  This gargantuan number is extremely difficult to comprehend, but it can be put into some perspective by realizing that the entire M2 money supply of the United States of America only crossed $3,419b for the first time in history a mere decade ago in April 1992!  Losing $3,419b is an unbelievable and unparalleled feat of folly!

In addition to witnessing trillions of dollars of dreams mercilessly vaporized, the brutalized NASDAQ faithful watched in horror as 15% of the companies listed on the high-flying index either careened into bankruptcy or were unceremoniously delisted.  With about 1 in 6 NASDAQ-listed companies suddenly going MIA or AWOL since March 2000, it is amazing that the swarming hordes of NASDAQ investors today are not more than a little bit worried about the loose standards of the NASDAQ for listing companies.

While the NASDAQ composite index lists and takes on increasing amounts of cold water, the current state of affairs in the market-darling NASDAQ 100, the mega-cap "blue-chip" NASDAQ stocks, is utterly appalling.  Although the NASDAQ 100 only contains 100 companies, a mere 2.5% of all the corporations listed on the NASDAQ, these mammoths comprise about two-thirds of the total market capitalization of the entire NASDAQ composite index.  For the most part, when people talk about NASDAQ investing today, they are discussing placing capital at risk in the elite NASDAQ 100 stocks.

At the end of January 2002, only a few short weeks ago, fully 47 of the NASDAQ 100 companies were operating at losses, a staggering percentage.  Of the 53 remaining companies that actually had some earnings, even if only pro-forma flights of fancy, fully half, 26 of the elite NASDAQ 100 members, had stellar price-earnings ratios exceeding a mind-boggling 50 times earnings!

Excluding the 47 losers and not deducting their losses from total earnings, the NASDAQ 100 had an unbelievable market-capitalization weighted-average price earnings ratio of 65.6 at the end of January!  While the number has exceeded 100.0 as recently as July 2000, it still remains vastly overvalued.  Fair value for a growth-stock casino like the NASDAQ is probably between 13x-20x earnings, nowhere near the current 66x level.  Yet the NASDAQ is still shamelessly hyped to investors like there is no tomorrow!

From any conceivable way that one objectively dissects and examines the NASDAQ, from all possible rational perspectives, it remains enormously overvalued in fundamental terms and ripe for continuing slides.  The fact to marvel at, however, is not that the NASDAQ remains so grossly overvalued even almost two years into the bust, but the frightening realization that NASDAQ investors are still blinded by the strong delusions perpetuated by the mainstream financial media that all is well and a major NASDAQ rally lurks right around the corner. 

After almost two years of abundant opportunities to dig into the NASDAQ, study it in historical and fundamental context, and make prudent decisions to evacuate capital to protect from the evolving NASDAQ bust, sadly very few investors have really taken the time to do their own homework.  Most current NASDAQ investors are apparently quite content to throw their scarce and hard-earned capital to the wolves.  Since they have forsaken so many abundant opportunities to sell in the vain hope that they can wait until the fabled next mighty rally to "break-even and sell", it is almost as if NASDAQ investors want to lose money.

Reading books on historical boom-bubble-burst-bust episodes is incredibly interesting and educational, but there is nothing quite like living through and witnessing a once-in-three-generation speculative mania in equities with one's own eyes.   The NASDAQ boom-bubble-burst-bust has been extraordinary in scope and magnitude, endlessly fascinating, scary at times, and always entertaining.  We are now blessed with the rare opportunity to witness in realtime the subtle shift in general NASDAQ investor psychology from naked greed to cold, dark fear.

While investor greed and fear are not easily empirically quantifiable, anomalous boom-bubble-burst-bust equity-index levels are certainly a reasonable proxy for these tricky emotions perpetually warring in the hearts of every single market participant.  Nowhere is this more evident than in classic boom-bubble-burst-bust graphs.  Our now familiar comparison between NASDAQ 2000 and the infamous DJIA 1929 episode that I have been discussing in these Zeal essays for most of the NASDAQ bear market continues to look eerily accurate.

Here is the latest iteration of our notorious graph first-published on August 25, 2000 when the NASDAQ composite closed at the lofty-height of 4043, far above current levels.  This graph is very simple and both axes are zero-scaled to eliminate distortions.  NASDAQ closing data up to February 20th, 2002 is included.  The spectacular NASDAQ top on March 10, 2000 is matched with the lofty DJIA top on September 3, 1929 and the daily closes of both famous bubble markets are plotted-out from there in a straight-up one-to-one fashion.  While the match is not exact, the overall rhyme and echoes of the historical 1929 bust in the current NASDAQ 2000 bust are absolutely uncanny!

NASDAQ vs. DJIA

Even though this simple comparison would never be shown on a hype-network like CNBC in a million years, it has helped thousands and thousands of investors understand the sheer magnitude of the NASDAQ bust early and evacuate the imploding market in order to preserve their scarce capital through the excruciating NASDAQ bust. 

Typically the financial networks, in their endless quest to help Wall Street deceive and delude investors into thinking that everyday is a great time to buy and that no one should ever sell, emphasize just the latest little NASDAQ rally from the post 9/11 lows rather than showing investors the strategic big picture.  Before the NASDAQ bust runs its full course, the legal firestorm that will eventually rage around the Wall Street hypesters for only reporting one side of the markets, the perma-bullish view, will be extraordinary.

Even without the benefit of the crucial valuation data discussed above, any NASDAQ chart since late 1998 should strike utter terror into the hearts of NASDAQ investors.  The evolving bust, as is quite evident above, has comfortably taken residence in a very distinct and unambiguous downtrend.  The two dotted-red arrows above mark the support and resistance lines for this trend pipe.

When the NASDAQ first plunged through the top of this new trend channel in early January 2001, Alan Greenspan launched the Fed's frantic assault on savers.  The doomed index rallied for less than a month after the first emergency surprise inter-meeting interest-rate cut by the Fed and then fell off a cliff again as more and more investors realized something was very wrong in NASDAQ-land.  After a near freefall into April 2001, the index dead-cat-bounced for another month and then began slowly bleeding throughout last summer.

Soon after the embattled NASDAQ started to nose-over and fail in late August, the malevolent Mohammedans made their fiery veto of Washington's interventionist foreign policy on September 11th, creating a great excuse for another steep sell-off in the NASDAQ which was arrested in late September.  Since its recent September lows, the NASDAQ has once again bounced nicely but repeatedly failed to break the top of its downtrend channel in December 2001 and January 2002.  Like a prehistoric insect trapped in amber, the NASDAQ has been locked in this ugly downtrend for more than a year.

How on earth can any honest investor or speculator on the planet possibly look at a NASDAQ chart of the last three years and give it a bullish interpretation?  That defies logic!  A boom led to a speculative-mania bubble, which is crystal-clear and undeniable on the chart.  That mighty bubble imploded under its own weight in a catastrophic burst (crash), which is also readily apparent on the chart.  Since the burst, the NASDAQ has been death-spiraling in a steep bust phase that has annihilated enormous amounts of investors' scarce capital.

It is absolutely crucial to note that since the burst there has not been a single major rally that has lifted the NASDAQ composite index up to an interim high that was higher than a previous interim high!

While the overall strategic perspective on the NASDAQ bust is certainly provocative and should be downright terrifying for anyone still playing the fool's game of being long the NASDAQ for more than a month or so at a time, the current tactical situation in the evolving bust appears to offer some wonderful trading opportunities for speculators.

Our next graph simply zooms in on the above graph since 2001 on the NASDAQ.  Also, the DJIA 1929 vertical axis, while still zeroed, is compressed slightly to make the relative percentage changes in each evolving bust perfectly comparable.  It is absolutely remarkable from a short-term perspective how closely the current NASDAQ emotional crests of investor greed and troughs of investor fear track the notorious DJIA bust from mid-1930 to mid-1931.

NASDAQ vs. DJIA

Even if the blue DJIA 1929 line was stripped-out of this graph, one has to wonder how anyone can even start to make the case that the recent NASDAQ trading action has been bullish.  Even in light of the most aggressive and utterly reckless slashing of interest rates in the entire disastrous 89-year history of the private US Federal Reserve bank, the NASDAQ continued to merrily commence its bust as if Greenspan and his market-manipulating socialist cronies didn't even exist.  Even Greenspan's diabolical war on savers could not scorch enough capital out of money-market accounts back into the rapidly deflating NASDAQ bust to make a noticeable difference.

Since March of 2000, after vehemently denying that there ever was a bubble for most of the first year after the NASDAQ crash, the Wall Street insiders now constantly try to reassure the ever more fearful American investors that bubbles are no big deal and do not have serious consequences.  As the charts above show, even with all the psychological warfare against investors and quasi-government market manipulation in the world, bubbles still do have consequences and those consequences are extremely ugly.

The older I become and the further down the path in this fascinating quest called life I find myself, the more amazed I am that the most useful wisdom in all aspects of life, including on the huge financial front, is the most elegantly simple truths that even a child can easily understand.

Want to make money in the markets?  Easy.  Buy low and sell high.

Want to grow wealthy?  Easy.  Spend less money than you make.

Want to get along with everyone?  Easy.  Love your neighbor as yourself.

Want to lose some weight and get in shape?  Easy.  Eat fewer calories than you burn each day.

The greatest wisdom in life, financial or otherwise, is often wrapped in the most simple and elegant basic truths!

Just as simple is the definition of a bear market.  A bear market is merely a series of lower lows and lower highs.  Look at the two graphs above and marvel at how anyone, especially the Wall Street carnival-barkers, can look at themselves in the mirror each day when they somehow try and twist a textbook post-bubble bust bear-market into some kind of wildly bullish tech stock scenario.  What gall!

The crucial buying low and selling high advice, the ultimate essence of all investment endeavor, can even be practiced on the long side in brutal secular bear markets such as our current evolving NASDAQ bust.  While shorting stocks can be very profitable and is certainly exciting, selling stocks short opens one up to the horrible risk of losing theoretically infinite amounts of capital if a trade goes wildly against the speculator.

When outright buying a stock long, say at $50 a share, the most one could ever lose, the worst of all worst-case scenarios, is the original $50 paid for the stock.  When selling a stock short however, say at $50 a share, the most one could lose is far greater than $50 per share!  Since selling short involves first borrowing a share of stock, then selling it, and later hoping to buy it back at a lower price to repay the debt at a future date, an unforeseen rally in a shorted stock can wipe out far more than one's initial risk capital.  For example, if the shorted stock rallied from $50 to $500 the next day, highly unlikely but certainly possible, the shorter would be on the hook for $450 per share!  It is no fun at all to get trapped on the wrong side of a short trade gone bad.

But thankfully, since not everyone wants to nor is equipped to short stocks, bear market rallies can also be profitably played on the usual long side.  Note in the graph above how the NASDAQ action of the last 14 months or so is neatly confined within a well-defined trend channel.  Each yellow triangle points to a lower low or lower high that marked a major turning point in the short-term NASDAQ trend.

On April 4, 2001 the NASDAQ closed at 1639 at the first yellow trend-change point marked on the bottom support trendline above.  Interestingly, at the time Wall Street and the financial media virtually universally proclaimed that the April lows would hold no matter what, that the worst was behind us.  We laughed at that typical Wall Street perma-bull drivel and published an essay on May 11, 2001 called "Equity Bulls in Denial" that explained why the April lows had no chance of holding in the next downleg. 

Only about six or seven weeks after the dismal April lows, the NASDAQ rocketed up to 2314 on May 22, 2001 for an awesome 41% bear-market rally.  After slamming into the resistance line, indeed defining the actual top trendline, the NASDAQ traded choppily sideways throughout the summer of 2001, heading ever lower into August.

As is readily apparent above, like a giant sine wave the NASDAQ was already falling faster and faster before the whole miserable September 11th episode.  On September 21, 2001, the NASDAQ closed at 1423, over 200 points lower than its interim April bottom, just as we had expected last summer because that's the way post-bubble busts have always worked in history.  Most contrarian investors believe that the NASDAQ would have made a similar lower low even without the 9/11 events to slightly hasten the short-term interim bottoming process.  On September 10th before the attacks the NASDAQ had closed at 1695, within spitting distance of the old 1639 April bottom.  Even without the Mohammedan terrorists wielding box-cutters, the NASDAQ would have almost certainly knifed through the April bottom anyway, probably within a week of the actual post 9/11 bottom.

Following its September lows, in one of the worst and most despicable recent abuses of the proud idea of patriotism, Wall Street and its sycophants in the mainstream financial networks shamelessly called on Americans to buy overvalued NASDAQ stocks out of patriotic duty.  Buying something for more than what it is truly worth is foolish and is bad for everyone, bad for both American investors and general US economic might, with the notable exception of the sellers, who were often Wall Street or corporate insiders who made out like bandits selling aggressively into the "patriotic" NASDAQ post-attacks rally.  This nauseous and vile "patriot rally" in the NASDAQ carried it to another top right on trend of 2059 on January 4, 2002.

After bouncing off its top resistance line in early January, the evolving NASDAQ bust is conforming perfectly to a declining bear market sine wave and is heading back south.  It will probably slam into and bounce off of the bottom support trendline sometime in the next couple months, probably around an index level of 1100 or so.  The white arrows in the graph above show the probable NASDAQ paths in the coming months and the lower black-dashed line outlines the 1100 index level at which the NASDAQ will probably bounce off the support of its well-defined bear-market trading-range trend-pipe leaving yet another lower interim bottom in its wake.

The more the NASDAQ chart is studied, the harder it is to believe that anyone can be bullish on the intermediate-term for the evolving NASDAQ bust!  Being a NASDAQ bull right now takes the deadly arts of wishful thinking and willful delusion to their absolute pinnacles!

So how does a rational speculator play the NASDAQ on the long side at this peculiar moment in history?  By following the sine-wave-like trend and by buying key NASDAQ 100 market-darling stocks when the bottom support trendline is being tickled by the NASDAQ index.

Each day a short-term NASDAQ speculator should surf to one of the gazillions of Internet sites that offer free charts, print-out a graph of the daily NASDAQ closes for the last 14 months or so, draw the trendlines connecting the two descending tops and the two descending bottoms, and then patiently wait until the NASDAQ approaches its next big bounce point near the lower support trendline in the coming months. 

Then, when that strategic junction in time is reached, turn on CNBC and buy whatever big-cap NASDAQ market-darlings they are relentlessly hyping at the moment, such as Cisco (8% of the total NASDAQ 100 market-capitalization), or Intel (13%), or Microsoft (19%).  These companies, of course, will still be vastly overvalued by all fundamental measures and are like holding radioactive-waste for long-term investors, but for a short-term speculative play valuation is far less important than market psychology, the intricate dance of general greed and general fear.

After buying near the bottom trendline, all our short-term NASDAQ speculator has to do is hold for a few weeks or months until the NASDAQ once again approaches the top trendline.  Then sell without remorse with both hands! 

Realize that one has to be a hardcore contrarian to pull this off, as fear will be widespread at the bottom support line when the NASDAQ is making another short-term interim bottom so it will be very hard to buy.  Also, when the NASDAQ later hits the top resistance line the bullish hype and greed will be overwhelming so it will take a strong contrarian to sell out when everyone is proclaiming a new bull market is being born.

So, yes, even in a brutal secular bear market after a bubble like the current evolving NASDAQ bust, it is indeed possible to play the bear market rallies and profit by buying and selling market-darling stocks near the key turning points of the trend channel.  The primary risk born by this play is that the trend will be broken, which can conceivably happen at any time.  Prudent speculators will deploy strategic stop-losses to minimize the risk if the NASDAQ jumps out of its trend channel rather than cooperating and continuing to decline in a nice orderly fashion.

For aggressive options traders who don't mind the high risk of losing 100% of the capital they paid to buy options if trades move against them, there are twice as many great NASDAQ bear-market opportunities to trade.  The most popular option contract in the world is the "cubes", or triple Q's, which are perfect for playing the NASDAQ bear-market sine-wave.  The QQQs are an exchange-traded proxy for the elite NASDAQ 100 market-darling stocks that trade under the symbol QQQ on the American Stock Exchange.

An options speculator can buy QQQ calls when the bottom support trendline is being teased by the ailing NASDAQ composite index.  Then, a few weeks or months later, the QQQ calls can be sold for huge profits as the NASDAQ nears its top resistance trendline.  The proceeds from those QQQ call sales can be immediately rolled over and plowed into QQQ puts when the NASDAQ is near its top trendline, betting that the index will soon start falling.  Then, a few weeks or months later, once the NASDAQ is yet again approaching its bottom trendline, the QQQ puts can be sold and the capital plowed back into QQQ calls.

This options strategy is simple and appealing, but it bears the substantial risk that the NASDAQ will suddenly jump out of its trend channel, either to the upside or downside, or that each subsequent wave of the NASDAQ's journey down will lengthen causing the options to expire before they are far enough in the money.  Nevertheless, for experienced options traders who fully understand all the risks and can easily afford the losses if their bets turn sour, trading the cubes on a contrarian basis is an attractive short-term NASDAQ-bust speculation strategy.

As the NASDAQ bust evolves, it continues to be amazing that anyone remains bullish on the index.  Its fundamentals are unbelievably atrocious and its technical charts are ominous.  Yet, humans being humans with immense emotional inertia too great to overcome for the majority of investors, tens of millions of people are still fixated on the last great bubble, hoping it will flare up yet again in tech stocks, instead of the next great bubble, probably commodities.

While long-term buy-and-hold NASDAQ lemming investors are going to get slaughtered like sheep before this grueling bust finally achieves its ultimate bottom, almost certainly below NASDAQ 500, the short-term NASDAQ speculators, whether they are short sellers, long buyers buying and selling stock to ride the rallies, or options-traders using the QQQ's to bet on the near-future direction of the NASDAQ, awesome profits are out there ripe for the taking.

Even in the dark midst of a brutal post-bubble bust that will ultimately grind out remaining speculative excess and terrorize investor greed into great fear, abundant trading opportunities still exist to build capital as the NASDAQ continues its death-spiral towards fundamentally solid ground far, far below current levels.


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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