Dow, S&P Near Main Bull Market Support

The Dow and S&P 500 neared their main bull market supports from 1982 yesterday, the first time in more than six years that they’ve approached those trendlines.

The main trendlines from the long bull market are not too much below yesterday’s lows (see charts below), say about 3%, at 8600 on the Dow and about 1010 on the S&P. The Dow also has potential support at 8800.

A good rally could materialize from those levels, but given how hard the indexes have rolled over, an eventual break of those lines is a distinct possibility, and a full retest of the October 1998 lows of 7500-7800 on the Dow and 920 on the S&P 500 would become the next targets. The S&P is now 33% off its all-time high of 1553, a greater decline than the index suffered in the 1987 crash, and the Dow is 24% off its all-time high.

One index to keep an eye on is the Dow Transports (see chart below). The index is right at its March 2000 and October 1998 low of 2060, and rolled over hard yesterday. Dow Theory, which states that the Transports and Industrials moving together make for a healthy market, is the oldest school of technical analysis. Other important sectors to watch are cyclicals, semiconductors and the Banking Index. Strong buying in those economically sensitive sectors could mean a good rally is coming.

Some possible stocks to keep an eye on. Boeing was crushed yesterday on the assumption that airline sales will suffer as a result of last week’s terrorist attacks on the World Trade Center and the Pentagon, and traders were already pricing in slower sales ahead of that tragedy. But what if Boeing were to win some of the coveted $200 billion Joint Strike Fighter contract, which most think will go to overpriced competitor Lockheed Martin ? At half Lockheed’s valuation, Boeing would become very compelling under that scenario. However, play it with caution; support should be found at 31, and the stock closed at 35.80 yesterday.

A second, and more intriguing idea, is OSI Systems , which makes optoelectronic devices used in medical diagnostics and aerospace and airport security applications. The stock soared 75% yesterday – but still trades below book value and at a price-to-sales ratio of less than 1.0. Support can be found at 6.50, and then at 4.

Finally, a word about some of the forces at work in this market. Some have speculated that derivative losses from the disaster could be huge; several counterparties have ceased to exist. If that is the case, this would become the second crisis in three years exacerbated by the massive derivatives industry. Another factor at work is repatriation; with a falling dollar and a falling stock market, U.S. stocks are a much less attractive place to be for foreign investors.

And then there is the possibility of massive losses in the futures market, which we mentioned last week. Complicated index futures trades made by the biggest financial institutions could be adding to market losses and volatility.

These index arbitrage trades have had the effect in recent years of stabilizing the market or driving it higher. But with the market’s decline the last few months, futures positions held by index funds and large institutions are suddenly under water, and if forced to close out these positions at a loss, could exacerbate selling in the market. That could be another factor at work here, and was probably affecting the market before last week’s disaster.

Index funds and others buying index futures can force the futures above fair value. When that happens, arbitrageurs will sell the futures and buy the underlying stocks, in effect taking advantage of the spread between the two. These trades are often called “computerized trades,” and the effect is to force the underlying index higher as long as the futures remain above fair value.

The problem is that the breakeven point for these futures trades is much higher than where the Dow is now for the futures expiring on Friday, according to one observer. Because of the sudden decline in the Dow, that means that the holders of these positions could either have to take losses at expiration or sell their futures positions before then to try to limit their losses. If they sell the futures, that would add to downward pressure on the market. If index funds were to experience sizeable redemptions at the same time that they were facing losses in the futures, the ensuing sell-off could be dramatic. This could be one of the Fed’s fears here – and one reason why a rally could materialize here, to reduce some of those losses.

But the massive trade in derivatives and index arbitrage positions probably hasn’t been looked at nearly enough by federal regulators. It could be a good topic for debate once the near-term crisis abates.

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