Printer Friendly

eMail Article

May 10, 2002

Massive Daily NASDAQ Rallies
by Adam Hamilton

The ongoing NASDAQ post-bubble bust process continues to be incredibly fascinating in a myriad of ways.

Like inherently unpredictable and chaotic ocean waves converging onto an island beach and creating beautiful patterns in the water, endlessly intriguing investor psychology waves constantly batter the embattled NASDAQ. The intricate interplay among the continuous variety of psychological waves of gluttonous greed and naked fear emanating from the investing hordes is mesmerizing as they clash to buffet NASDAQ prices.

Watching a doomed supercycle bubble patiently and methodically lead general investor psychology from euphoric speculative mania footing to huddling in terror in a corner has to be one of the greatest spectacles in market history. It is terrible and sobering to behold but the lessons learned will last a generation or two until the next mighty speculative mania in equities erupts.

Like driving by an automobile accident on the freeway, watching the unfolding NASDAQ bust is also sort of a guilty temptation, its colossal psychological gravity causing investors worldwide to slow down and rubberneck to drink in the grisly carnage. Even though it is truly sad when any investors lose money, we humans can't help but be magnetically drawn to the travail and trials of the twisted and smoldering financial wreckage following a supercycle speculative mania bubble.

Most importantly in my humble opinion, all investors and speculators are now granted a wondrous textbook-perfect opportunity to glean immensely important lessons from the NASDAQ bust that will last a lifetime. The world's best investors and speculators fully realize that they will always be merely students of the markets, that every single day in which they are alive and watching the markets and trading is a golden opportunity to deepen their understanding of the infinite complexities and subtleties of the markets and the forces that ultimately move them.

As a mere student of the markets myself, committed to a lifetime of trying to discern their subtle patterns, secrets, and nuances, I continue to feel like a kid in a candy store because I am greatly blessed to be living and trading in such a rare time in history defined by a once-in-three-generation supercycle boom, bubble, burst, and bust. There hasn't been a similar opportunity to observe such an awesome event firsthand and in real-time for almost seven decades in US equities, and the 1929 troubles were well before my time.

One NASDAQ bust topic in particular continues to intrigue me and I suspect legions of other investors and speculators out there as well, the fascinating realm of bear market rallies.

Since the enormous post-9/11 bounce in the NASDAQ, I have penned four essays on the important and intriguing phenomenon of NASDAQ bear market rallies. November's "Bear Market Rallies" took a macro-view, investigating the major strategic bear market rallies of the NASDAQ bust in the illuminating light of the infamous 1929 DJIA bust. In February's "Trading the NASDAQ Bust" we looked at some short-term speculation strategies to profit from the unfolding NASDAQ debacle, with a heavy emphasis on being on the right side of the seemingly endless parade of spectacular bear market rallies.

In March's "More Bear Market Rallies" we examined the current great bear market rallies of the Big Three US equity indices in technical and fundamental terms, bucking the bullish consensus at the time and declaring the exciting events nothing more than deceptive head-fakes by the markets to wring ever more dollars out of the bleeding bulls. In April's "Bear Market on Target" we took a look at the utter uselessness of deploying simple moving average index crossovers as predictive tools in primary bear market environments.

Now in May, just as I thought that we had finally published enough recent essays on bear market rallies, the NASDAQ continues to astound and demanded yet another bear market rally essay. Who am I to refuse such a tempting offer?

On Wednesday May 8th, the day following an apparently positive earnings announcement by NASDAQ bubble darling Cisco Systems, the King Bubble of the NASDAQ speculative mania which still has throngs of fanatical followers, the besieged NASDAQ index exploded upwards with great fury, reaching for the heavens in a rally of Biblical proportions. In a single trading day the NASDAQ composite rocketed up by 122 points, 7.8%, to 1696! It was truly a wondrous sight to behold.

Now I don't care whether you are currently a bull, bear, agnostic, or apathetic, the breathtaking May 8th NASDAQ action was spectacular by any investor's or speculator's standards!

As we are actively shorting the doomed NASDAQ for reasons articulated in many past Zeal essays, one of my partners and I watched the massive NASDAQ rally unfold on Wednesday with great interest. By the end of the day when the dust settled we were pretty convinced that it was simply a rather large garden-variety short-covering bear-market rally, and it got us thinking about massive single-day bear market rallies in general.

We have discussed multi-day, multi-week, and multi-month strategic bear market rallies in great depth in past Zeal essays, but hadn't yet looked into gargantuan single-day bear rallies. What an opportunity!

After the markets closed on Wednesday we began crunching the numbers and found that the May 8th 7.8% melt-up was the 8th biggest daily rally in the three-decade history of the NASDAQ. Quite impressive! In digging deeper it soon became apparent that massive record-breaking single-day bear market rallies in the NASDAQ exhibited very important distribution patterns of which all investors and speculators need to be aware. These revelations to us led to this essay on massive single-day NASDAQ rallies.

For this essay we decided to limit our dataset employed to all the NASDAQ composite closing data since January 1990. This decision was made in order to attempt to make our research this week as relevant as possible to today's investors and speculators. We wanted to exclude the 1970s bear market in equities as well as the 1987 crash so our single-day bear market rally investigation would focus solely on massive daily NASDAQ rallies during the greatest bull market in NASDAQ history, which unfolded in the 1990s. Interestingly, we did run the full historical NASDAQ numbers internally and the conclusions drawn are identical even if all the NASDAQ historical data is used rather than only 1990 onward.

Before we begin a quick thought exercise is in order.

Imagine asking an investor friend of yours to share his or her intuitive thoughts with you on massive single day NASDAQ rallies, measured in percentage terms to ensure comparability across different index base levels over time. You tell your friend that massive daily rallies of record-breaking magnitude are not randomly distributed on the evolving NASDAQ timeline but clustered around certain events. You then ask your friend when he or she thinks that most of the biggest daily rallies in the last twelve years or so occurred in the NASDAQ.

I suspect that 90%+ of the investors of which you ask this question will say that most of the biggest NASDAQ single day percentage rallies must have occurred during the spectacular boom and bubble of late 1999 and early 2000 when the index was roaring ahead into the stratosphere day after day, seemingly unstoppable. After all, shouldn't the very best days in NASDAQ history occur during the very best rally in NASDAQ history?

If this hypothesis was indeed true, if the greatest single-day rallies occurred during mega-bull runs, then huge up days would be incredibly bullish omens. Provocatively however, the greatest NASDAQ daily rallies actually occurred not during the boom or bubble peak but during the subsequent bust! Please ponder this counter-intuitive fact for a moment, as its implications are profound.

Massive single-day NASDAQ rallies are not something that the bulls should joyously celebrate, but are ominously bearish portents of future downside trading activity in the index!

Between January 2nd, 1990 and May 8th, 2002 there were 3,116 trading days for the NASDAQ. If you carefully dissect this quivering mass of raw data with a computer scalpel you will discover that of the top 50 biggest single-day rallies in percentage terms on the NASDAQ, an incredible 36, or 72%, occurred after March 2000, the month that the NASDAQ peaked at its all-time closing high of 5049 at the very apex of the great supercycle speculative mania bubble!

Of the top 25 biggest NASDAQ daily rallies since 1990, 22 or 88% occurred after March 2000, in the midst of the raging bear of the NASDAQ bust! Every single one of the top 10 largest NASDAQ daily rallies in percentage terms, of which this week's exciting May 8th, 2002 rally was the 8th largest, occurred during the horrific NASDAQ bust since March 2000! Interestingly, these top 10 NASDAQ daily percentage rallies in our 1990-onward dataset constitute the entire population of the elite NASDAQ 7%+ club, daily rallies melting up 7% or more.

Our first graph this week, modified from one we originally ran in "US Equities: A Strategic Perspective", has these top 10 NASDAQ daily percentage rallies listed on the left as well as the top 15 plotted on the index graph next to the day they occurred. Provocatively you have to run the record list all the way down to the 15th largest single day NASDAQ rally in history, 6% on September 8, 1998, to find the first showing of a non-post bubble top massive single day NASDAQ rally.

The yellow line above is a normal 7.5% average historical equity return line, showing what a non-bubble NASDAQ should have done in the 1990s as a baseline to illuminate the gross extremes of the actual bubble that unfolded (our third graph below also has this same yellow reference baseline included). The dashed-red line is the hyper-critical NASDAQ support line around 1420 that marks the October 1998 post-LTCM crisis lows and the September 2001 post-9/11 crisis lows. When this Maginot Line is inevitably decisively broken, veteran NASDAQ investors' confidence could be shattered, professional and amateur alike. NASDAQ 1420 is an important, important, important technical level to watch!

Although it is not perfectly apparent due to the space constraints above, every single one of the top 14 daily NASDAQ rallies since 1990 occurred after March 2000, to the right of the apex of the NASDAQ bubble in the graph. If you happened to be a long-term NASDAQ investor and you decided to purchase stocks on the very euphoric days of the greatest massive daily NASDAQ percentage rallies, you would have been slaughtered like a lamb. Every single one of the top 14 NASDAQ daily percentage rallies soon collapsed to new lows within weeks or months after each enormous rally first captured investors' attention and affections.

Massive single-day rallies in not only the NASDAQ but also probably in any equity index are almost exclusively a bear market phenomenon, occurring during intense short-covering frenzies punctuating the inevitable dull downward spiral of primary bear markets. Huge daily rallies are not a bullish hint of great things to come from stocks, but an incredibly bearish release of steam from the pressure-cooker of collapsing markets!

Extreme daily bear market rallies of this record-breaking magnitude are almost exclusively caused by short covering. The fearless speculators who actively short the equity markets render several great and exceedingly important services for all investors. Every normal long-term buy-and-hold investor ought to really admire these shorting folks for the crucial role they play in counterbalancing dangerous market excesses that can lead to severe capital losses.

A short-seller simply reverses the temporal order of the ancient core-investing mission of Buy Low Sell High. A short-seller borrows shares of a stock from a broker, sells them high in the open markets today, and hopes to buy them back low in the future to repay the loan and provide a profit on the speculative trade. This act of shorting, of betting against stocks, serves incredibly important functions for the general health and well-being of the financial markets in a couple major ways.

First, like a pride of lions on the African savanna taking down a wounded wildebeest, short-sellers help cull the herd of investments so only the strong and healthy companies thrive to attract long-term investors' precious and scarce capital. Short-sellers take on potentially unlimited risk in placing their speculations, so they are generally very careful only to short companies that are either vastly overvalued in fundamental terms like Cisco Systems was in March 2000 or companies run by criminals and doomed to implode like Enron of late 2001.

Without short-sellers, unhealthy companies would fester longer at inflated stock prices and normal long-term investors would lose vastly more capital from valuation-induced slides and Enron-type debacles without the lionhearted shorts carefully picking over the investment herd and taking aim at the dangerous and unhealthy corporate losers.

Second, when the markets are falling fast, it is absolutely crucial that someone, somewhere, buy some stocks immediately to halt the freefall. Short-sellers are often the only source of consistent stock demand in times of extreme market weakness. As prices fall lower and lower the shorts become more and more tempted to buy back their borrowed stock to cover their short positions at a profit. If short-sellers didn't exist market plunges would be much more catastrophic as crucial stock buying demand during severe market travails would simply evaporate.

The greatest daily NASDAQ percentage rallies since 1990 have all been launched on short-covering in primary bear markets. They all occurred during times of severe market weakness when few other speculators were willing to buy to place a bid under the markets. As soon as a small group of short-sellers begins to cover their positions in a falling market, prices can start to turn higher rapidly. This in turn spooks other short-sellers to pursue a similar course of action and a massive single-day short-covering frenzy is ignited. Because the shorts risk theoretically unlimited losses in big rallies in their shorted positions, they have to buy back and cut their losses almost instantly to manage their risk.

It is not at all surprising that the biggest and most awesome rallies in the NASDAQ, and indeed all equity indices, occur on days of pronounced short-covering. These massive single day rallies are extraordinarily bearish omens since short-covering rallies emerge out of nowhere with intense fury but then vanish within mere hours or days like a desert oasis mirage. Without sustained normal long investor demand for stocks, any meaningful long-term equity market rally is all but impossible.

Interestingly, the biggest NASDAQ daily rally ever, an unreal 14.2% explosion on January 3rd, 2001, was launched on a titanic short-covering frenzy spawned by Alan Greenspan's first surprise inter-meeting interest rate cut. I wrote an essay the day after that event called "The Greenspan Gambit" that includes intraday graphs that show the violent rallies that ensued when total fear gripped the market shorts.

As every single one of the top 14 rallies in the NASDAQ since 1990 occurred after March 2000, these massive daily rallies have a perfect 100% track record of being deceptive and dangerous. Any bullish long-term investor who was enticed to buy on these seducing rallies has so far been massacred in the ongoing NASDAQ bust. Should we expect this unblemished bearish track record of mega-daily NASDAQ rallies to suddenly reverse on May 8th's spectacular 7.8% rally, the 8th biggest NASDAQ daily rally in history? Of course not!

Our next graph this week is an update from "Bear Market on Target" which helps illuminate the magnitude of the May 8th rally in the crucial strategic context of longer-term trends. Any of the top 25 massive daily NASDAQ percentage rallies since 1990 which occur in this graph's timespan are noted by white numbers beside the day the rally occurred. A white "3", for example, means that the 3rd largest NASDAQ daily rally since 1990 (and indeed in history, since the NASDAQ was not too exciting before the 1990s, truth be known) occurred next to it on the graph.

While a single day 7.8% rally is certainly impressive when you are trading through it and watching it in real-time, a simple long-term chart shows how small it ultimately is in the grand scheme of things. If you just happened to glance at the blue NASDAQ line above and had no idea where the big daily rallies occurred they certainly wouldn't jump out at you from the mere visual time-sequence data. This is yet more irrefutable evidence that massive daily rallies in equities are a bear market phenomenon preceding further falls and absolutely not a bullish omen.

Even more important than the single-day bear market rallies in this graph is the ominous Fall of the Midline!

Three weeks ago in April's "Bear Market on Target" essay I first discussed this ever-more-apparent new trendline, not the major bottom support or top resistance of the NASDAQ's primary bearish trendpipe but a quasi-support line in the middle, the midline (the dashed-red center line above). Since the bubble burst the NASDAQ has only violated this line to the downside three times, twice in 2001 and just last Friday May 3rd in 2002. All three episodes are highlighted with dashed-yellow circles above.

Very provocatively, even quite ominously, both times in 2001 when the NASDAQ couldn't hold this midline the embattled index soon after rapidly plunged a long, long way down all the way to its heavy bottom support line. As the graph above clearly shows, even in summer 2001 before the September 11th mess the NASDAQ had already plummeted soon after it violated its midline, closing at 1695 on September 10th when most of the world had never even conceived of turning a fully-loaded commercial airliner into a skyscraper-leveling weapon of mass destruction.

When the midline actually held as support, marked above by the 4 yellow arrowheads, awesome bear market rallies ensued, some lasting one day and some lasting longer. But, as soon as this midline has been violated in the recent past, confidence in the NASDAQ fades fast and a rapid drop to new post-bubble lows ensues.

The magnificent May 8th NASDAQ rally was perfectly timed to bring the NASDAQ back above its crucial midline, now at roughly 1650 or so, but only time will tell whether it was enough. Note that back in August 2001 when the NASDAQ last broke its midline to the downside that a sharp rally rapidly ensued that carried it back over the midline, but it soon failed and the NASDAQ began its long spiral down on a steep slope well before the September 11th market turbulence.

The May 8th action sure looks like déjà vu at this stage, eerily echoing August's last midline failure. If NASDAQ 1650 doesn't hold, if we continue to trade under this crucial midline level, I still strongly believe that there is a large probability of yet another fast slide to the bottom of the trend channel. NASDAQ speculators absolutely need to monitor this midline on a daily basis.

How low could the NASDAQ plunge in its next strategic short-term rout if the midline has really fallen and confidence in the overvalued tech-laden disaster of an index nears extinction? A long way dear friends!

Our final graph this week is a spiritual descendant of one from "Trading the NASDAQ Bust" where we had the brazen audacity to suggest that NASDAQ 1100 was a reasonable short-term target. It remains to be seen whether this particular technical prediction will make us look like fools or darned lucky buggers, but you have to admit this graph is quite interesting and provocative!

With the graph axes modified slightly to provide the proper perspective for seeing the whole NASDAQ trend pipe at once, the bottom support of the strategic NASDAQ bearish downtrend channel is running a little above 1100, which is an enormous 35% loss from current 1700-ish levels on the NASDAQ!

Could it really happen? Could we really see an interim low of 1100-1200 on the NASDAQ in 2002? You better believe it!

As I have said in past essays, technical analysis alone is of questionable value. But when prudent technical analysis is combined with sound fundamental analysis, a very powerful and potent analytical force is unleashed.

Stocks are ultimately purchased by investors because they want a fractional share in the future business earnings of the companies they buy. Corporate earnings are the single most important long-term fundamental attribute to use as a baseline to evaluate stock prices. Hence the widespread historical use of the mighty P/E ratio for providing a judgment on long-term valuation for stocks.

Like ancient Roman emperors presiding over gladiatorial combat, a simple P/E ratio can give an authoritative thumbs-up or thumbs-down for the valuation of a mature individual stock or even an index as a whole. If a stock is trading at a low price relative to its earnings, under a P/E of 13.5, it is potentially a good buy and it gets a thumbs-up and lives. If a stock is trading at a high price relative to its earnings, well over a P/E of 13.5, it is probably not a good buy, a thumbs-down.

As of April 30th, the last time we calculated this number at Zeal, the elite NASDAQ 100 stocks, which constitute roughly 2/3 of the total market capitalization of the NASDAQ composite, had a market-capitalization weighted-average P/E ratio of 56.2! This staggeringly high number is vastly overvalued by all historical standards and implies that the elite NASDAQ stocks can only manage to earn enough meager profits today to fully cover the price that investors are now paying for the stocks in 56 more years, ceteris paribus. Needless to say most investors today won't be around 56 years from now and this extreme fundamental valuation is ludicrously high!

Now if the NASDAQ was currently trading at 13-20 times earnings I wouldn't think the technical bearish charts were all that important. But with a mega-bearish strategic trend chart combined with fundamental valuations four times higher than fair value, the 1100 short-term bottom technical target on the NASDAQ has great credibility. Here is one scenario of how it could get there.

When the midline around 1650 is finally decisively broken, more and more market technicians will grow worried and selling will intensify, probably pushing the NASDAQ down below 1500 within a few weeks. NASDAQ 1500 is a big, round, scary psychological milestone that will cause a lot of general retail investor confidence to evaporate like a building after an atomic blast.

When 1500 finally falls the next target will be the crucial 1420, the hugely-important support level between October 8th, 1998's closing low of 1419 and September 21st, 2001's closing low of 1423. Once 1420 falls, Wall Street prophets of doom will run through the streets of New York City like a plague of locusts with cardboard "The End is Near!" signs hanging from their shoulders. The shattering of the 1998 and post-9/11 lows will be the psychological equivalent of a sledgehammer smashing already fragile NASDAQ investor confidence on the hard anvil of bear-market reality.

It is not a long way from NASDAQ 1700 to 1420, and from there it's only a hop, skip, and a jump to 1100-ish! Look out below!

With the current abysmal earnings for the NASDAQ companies even an 1100 composite index level is not an ultimate long-term bear-market bottom low, only an interim short-term panic bottom like we witnessed in April and September of last year. Unless current corporate earnings for the NASDAQ-listed companies miraculously explode to the heavens, the long-term ultimate bottom target for the NASDAQ is still under 500, as hard as that may be to stomach.

If you are a short-term speculator, not a long-term investor, as soon as the NASDAQ trades in the 1100-1200 range you should sell all your NASDAQ puts, cover your shorts, and buy NASDAQ calls and go long NASDAQ stocks and futures like there's no tomorrow. Note in the graph above how both of the plunges to the NASDAQ's bottom support trendline were extreme and sharp in 2001. As the NASDAQ starts plummeting vertically and approaching this crucial 1100-1200 level and general NASDAQ investor negativity and pessimism waxes deafening, that is when to line up and buy, buy, buy for a short-term couple-month-long NASDAQ speculation. NASDAQ 1100 is a mega-huge buy signal for the specs!

The bottom line is that record-breaking massive single-day rallies in an equity index are almost always short-covering rallies in primary bear markets. Whenever investors witness a spectacular daily rally in the NASDAQ or other stock index that is among the largest ever, they should not interpret it as a joyous sign of a turnaround but they should run for the hills to preserve their scarce capital from the evolving hungry and vicious bear.

Massive daily stock market rallies of the necessary magnitude to enter record territory are not glorious buy signals for the bulls, but unambiguous sell signals to get the heck out of dodge. Bear markets, especially after supercycle bubbles, take no prisoners and leave few survivors.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

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.

Copyright © 2000-2009 Zeal Research

Image rendition and html coding Copyright © 2000-2009 SafeHaven.com

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »