Interesting observations in this morning's WSJ:
March 4, 2002
Sharp Lurches in Stocks May Signal
That Market Is Poised for Rebound
By E.S. BROWNING
Staff Reporter of THE WALL STREET JOURNAL
The stock market is off to a volatile, nerve-jangling start this year -- and that could be good news for nervous investors.
Analysts say the unusual run of big gains and losses in recent weeks, including a 262.73-point gain in the Dow Jones Industrial Average on Friday, could well be a sign that the market has hit bottom and is starting its turnaround.
"It is probably a sign that the tide is trying to turn here," says Tim Hayes, global stock strategist at market-research firm Ned Davis Research in Venice, Fla. "In most cases in the past, this is the kind of thing that occurs around a bottom. In fact, just about the only time it has happened is around bottoms."
An analysis by Ned Davis Research of the past six decades of trading shows that stocks generally don't fall very far after experiencing this kind of volatility. And while it also doesn't suggest that the market is about to take off like a rocket, it could mean that the major indexes are, however slowly, forming a base from which they can rise.
A wide variety of stock strategists, in fact, warn that a single-digit gain for the Dow Jones Industrial Average and the Standard & Poor's 500-stock index is the most investors should expect this year. Right now, the Dow industrials are up 3.5% so far this year, but the S&P 500 still is down 1.4% and the beleaguered Nasdaq Composite Index is down 7.6%, despite a 4.1% gain on Friday.
The sharp lurches of the past several weeks are highly unusual for the staid Dow industrials. During one period of 19 trading days beginning late in January, there were 12 days when the industrials moved more than 100 points (1%) -- rising on eight of those days and falling on four. One day they lost 158 points and the next day they gained 196. For last week as a whole, they rose 4.02%, or 400.71 points. Friday's 2.6% jump marked the biggest gain in the Dow industrials since Sept. 24, soon after the market bottomed following the terrorist attacks.
Unlike the volatile Nasdaq composite, with its twitchy tech stocks, the Dow industrials are dominated by established companies such as General Electric and Alcoa. For comparison, last year was an unusually volatile year for the industrials, but the index still recorded only 97 days with 1% moves out of 248 trading days -- less than four days in 10.
A look back at history, in fact, shows how unusual it is for the blue chips to have the kind of volatility they have had in the past month. Periods of such intense volatility tend to crop up at turning points in the market -- usually at times when the market already has fallen heavily and is preparing to resume its rise, according to Ned Davis Research.
Several such periods occurred in 1974, soon before the market turned up. It happened again in 1982, after a long slump, in 1987, around the time it hit bottom following the crash, and in 1998, when the market rebounded after the Russian debt default. Finally, it happened again in September of last year, as the market bottomed following the terrorist attacks.
But volatility isn't a perfect indicator. The Dow industrials gyrated sharply in 1973, when stocks still had further to fall. Then, after a period of volatility last spring, stocks rebounded, but then ran out of steam. All of that means there is no guarantee the current rebound will last. But over the past few decades, the high volatility generally has signaled the likelihood of a coming rally.
One explanation for that, which applies this time, is investor psychology. After a big market drop, shell-shocked investors have a tendency to cash in their positions once they post gains, for fear that stocks will fall again. That helps explain why stocks have had trouble sustaining gains in recent weeks. But lately, more bullish investors have been stepping in to buy beaten-down stocks, preventing declines from accelerating. This, traders say, looks like a classic case of base-building, with indexes showing a lot of choppy ups and downs within a broad range.
Many investors want to get into the stock market now, says money manager and analyst Laszlo Birinyi of Birinyi Associates in Westport, Conn., but the soft economy leaves them unsure of where to put their money. That may help explain why no sector has emerged as a strong leader, he says. "People really don't have any conviction about areas and sectors," Mr. Birinyi says. "The flesh is willing but the spirit is weak."
Another reason for the market's volatility is the growing influence of hedge funds, those exclusive "hot money" investment vehicles that once were reserved for the very rich. Hedge funds are little-regulated pools of investment funds that often trade actively, looking for quick profits. Once a small part of the market, they have been proliferating as wealthy but less-sophisticated investors have sought ways to make money in a weak market. Many banks, brokerage firms and even mutual-fund groups have begun creating hedge funds, to keep their wealthy clients from jumping ship.
One result: Hedge-fund assets soared 24% to $507 billion last year, partly due to fresh inflows and partly due to successful investing by hedge-fund managers, according to New York's Hennessee Group, an adviser to hedge-fund investors. Assets held in all mutual funds, in contrast, stagnated last year, according to the Investment Company Institute, a mutual-fund trade association. Assets held in stock mutual funds actually declined due to the weak market.
Hedge-fund managers typically trade much more actively than other money managers. If a short-term bet succeeds, a hedge fund often will cash it in. If it fails, the hedge fund often will sell it anyhow and try again. That creates volatility.
And unlike most mutual funds, hedge funds also bet on stock declines, using a technique known as short selling. To do that, they borrow stock, sell it, and then hope to profit by buying the stock back cheaper after it falls.
Short selling tends to increase short-term market volatility, because opening a short position requires heavy selling, and closing the position requires sudden buying. Moreover, short sales often come during market declines, reinforcing the decline. And when a short seller closes out his position, it can serve to exaggerate a market rally.
As a result, heavy short selling fuels both short-term drops and short-term rebounds. Lately, traders say, more-conservative investors have been investing tentatively, so that short sellers and hedge funds have been unusually influential.
"Plain-vanilla institutions that just buy stock have been inactive," says Tim Heekin, director of trading at San Francisco brokerage firm Thomas Weisel Partners. "They lost massive amounts of money in Enron and Tyco. The only class of investor that just seems to be in there every day and making a lot of money on the short-selling side has been the hedge-fund community. Every time there is a rumor about troops landing in Iraq or a Greenspan comment, they pounce on it."
Write to E.S. Browning at jim.browning@wsj.com1
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