Fear of the Double Dip


The stock market is in a bottoming process but may still see a good deal of sideways action. That's the verdict of Paul Cherney, market analyst for Standard & Poor's, who combines the skills of technical and fundamental analysis to probe market action.

Cherney's big concern about the market is its reaction to the threat of a double-dip recession -- emphasized by recent economic news. The worst-case scenario for the market, he says, would be a close of 800 on the S&P 500 index (it closed at 834 on Aug. 5). He observes that the questions raised about corporate accounting put the true amount of earnings in doubt and thus render price-earnings ratios harder to assess.

Price is the indicator he looks at first in studying a stock chart, Cherney says, but volume is also important. He likes to see volume increasing along with price. Another measure he values is the volatility index, or VIX, which shows a reading that often occurs at a primary market low -- a hopeful sign.

Cherney made these comments in a chat presented Aug. 1 by BusinessWeek online on America Online, in responding to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

Q: Paul, what do you make of this continuously seesawing market? Are we anywhere near the bottom many people talk about?

A: We are in a bottoming process. Last week's VIX [volatility index] move above the 50 level, and then the close below it which occurred on Wednesday, often occurs at a primary low...we have normal risk for an S&P 500 close of 822. A worst-case scenario would be an 800 close.

Q: You mentioned the VIX -- do you see any end to this volatility?

A: Unfortunately, I think volatility will still be a factor for the next couple of weeks. The big problem the market faces right now is renewed concern about a double-dip recession, and the economic reports we have seen over the last couple of trading days have done nothing to dispel those fears.

Q: With the S&P index's average p-e 21, do you still see more downside until we reach the lows?

A: Unfortunately, I can't rule it out. The technical conditions of last week on average spur net gains for about 15 or 16 trade days, but this is largely a technical reaction to extremely oversold fear-driven selling. I'm concerned about the p-e, mostly because right now, with the accounting problems, people don't really know what the p-e is. I have seen so many different views of the p-e, whether it's trailing, whether it's pro forma for 2002 estimates, pro forma for 2003 estimates. I think the markets are in for a good bit of sideways action. Some of it could set lower lows than what we've seen, but the mending process will take time.

Q: Other than the VIX, what should we be looking at? Is the VIX the only key index to watch for now?

A: Well, when you retest a primary low, prices can move below the price range from that day, and I would be referring to price action from Wednesday, July 24. One of the items I look for is much smaller volume...less than the 50-day moving average of volume. I would love to see high put/call ratios on a retest.... The next thing you need to see is a lift in prices that exceeds the highs of the day before the retest.

Q: Paul, do the fundamentals of the economy worry you? There have been some negative reports in the last several days.

A: My big concern is that the consumer might step back.... This has been the backbone of hope for the economy. Today's announcement that June construction spending dropped 2.2%, the ISM manufacturing index down to the low 50s, and concerns today about an increase in applications for unemployment -- these are the headlines that are reigniting fear in the marketplace. And this market over the last couple of years has demonstrated the ability to sell first and ask questions later.

Q: You seem to believe [Morgan Stanley economist] Stephen Roach's double-dip theory [which he proposed as early as late last year].

A: I pass him on the street almost daily, but I've never asked him to elaborate. There is validity to his argument, and we can all see the fear inherent in apprehension of a double dip in today's market and in yesterday's market, as we saw weak economic reports raise concerns. I think if the housing market starts to weaken, then the consumer might be less willing to spend, and to me, that represents legitimate concern. I want to qualify these observations by reminding everyone that I am NOT an economist.

Q: Do you think the Federal Reserve will lower rates, and if so, will this be a stimulus for the the market?

A: Right now, the Fed has no reason to lower rates. Continued signs of economic weakness will weigh upon the easing side of the scale. If they cut, will it do any good? All I'd do is look to the most aggressive easing in the history of the Fed, which occurred in 2001. And it did nothing to help markets that suffered from extreme overvaluation, based on felonious balance-sheet numbers. So no, I don't necessarily think that another easing by the Fed would do anything more than cause a two- or three-day reaction in the markets.

Q: Do you think most CEOs will sign off on their financial statements by Aug. 14? And if enough of them in big-name companies don't do it by then, will the market suffer?

A: If we don't get 90% of those 970 or so companies to sign those affidavits, I do not think it would be good. We might not sell off terribly but there would be no impetus to be an aggressive buyer. People can monitor who has submitted signed affidavits by logging onto www.sec.gov.

Q: What are your thoughts on EMC

and JDSU

(JDS Uniphase)?

A: EMC actually looks a little interesting right now. It appears to be forming a platform well above the lows it experienced in June. I don't know whether this will happen, but a move above 9.41 could generate another 1.5 to 2.5 higher in price. It looks O.K., but I would wait to see it move above 9.41.

There's nothing I like about the chart for JDSU. It has recently moved to new lows, and the trend is decidedly down. This price would have to base probably for two or three months before I would believe any move above 4.07. That is the upper edge of immediate resistance.

Q: Where is a good buy point for Wal-Mart (WMT)?

A: I like to see a stock demonstrate the ability to move higher before a long position is considered. This chart pattern looks constructive right now. As long as there is no undercut of 43.72, then a move above 49.70 could easily see follow-through and prints of 53-56.

Q: We're halfway through the year -- can you go out on a limb here? Where do you see the S&P 500 at the end of the year?

A: If we don't get more signs suggesting a double dip, the best I could imagine for the S&P 500 would be something in the 1050-1100 range. That's the absolute best. I think anyone should be happy with that, considering the recent low of 775.

Q: Do you think that the expensing of options will affect p-e's significantly?

A: The numbers I've seen are really kind of minor, in single-digit percentage impact. So no, I don't. Especially since pricing models that they're going to use are probably going to price them relative to exercise prices, and most of the stocks are down so far that those prices are a long way away. I think it's proper that options be expensed. And I also would like to see some sort of legislation that divides, and makes into a separate unit, pension funds, so that excess returns cannot be used to pad the bottom line in earnings reports.

Q: Any thoughts on AOL

(AOL Time Warner)?

A: Four months ago I was asked for my chart opinion on AOL. And I will share this with you as long as you don't tell anybody. The stock at the time was 18 and change. And the chart, to me, looked terrible. I did not say it, but I wanted to say, when asked my opinion after looking at this chart, I'd rather be blindfolded juggling knives than be long AOL. My opinion has changed only a little. It appears as if AOL could be starting a lateral base, but more time will be required to mend the broken bullish hearts.

Q: When looking at charts, do you look at the volume or price first?

A: Price is what stocks are bought and sold at, so price is the first consideration. Volume is important, and I use it in most of my important studies of market action. Generally speaking, you like to see volume increasing at a modest pace as prices increase, because it means that more and more people are attending the party. When you see a spike move higher in price, which generates a big spike in volume, you have to become wary, because you may have seen capitulation buying. And a retracement after a price spike, combined with a volume spike, will probably garner buyers again. However, the next move higher in price, if that's not accompanied by even higher volume than the first spike, then interest is waning, and I would pull stop losses up tight underneath the prices as they rise.

Q: I am 19, and my dream is to become a stock analyst -- what advice do you have?

A: If you want to be a fundamental analyst, you would have to take the regular college courses in accounting, finance, and economics. I would warn you also that fundamentals which are not reflected in prices relegate the analyst to also understanding a little bit about charts. The best balance sheet in the world, the best earnings in the world, that do not generate higher stock prices make a stock

not worth owning, regardless of how good it looks fundamentally. And I think this is one area where many fundamental analysts fail to produce terrific calls. You have to understand that if the market is not interested in owning the stock and is not paying a higher price than the previous buyer of this stock, then it is simply not worth owning.

Q: What is your opinion on Newmont Mining (NEM)? Is it gold's turn to make money after a 20-year bear market?

A: Unfortunately, I do not share the great expectations that some people have for gold. The biggest reason that I don't is because the futures markets -- not commodity futures, I'm talking about index and currency futures -- have usurped the value of parking money in gold. And for this reason, gold is no longer the safe haven of last resort.... If gold were the storehouse of value that it historically had been before such elaborate hedging in futures came into existence, then it should have been $600 during the currency crisis that circumnavigated the globe from July '97 to October '98. And it wasn't.

Q: Just took a look at the 10-year DJIA chart. Isn't that the classic head and shoulders? (Define head and shoulders quickly for the innocent.)

A: It does look that way, doesn't it? A head and shoulders formation is: A high is established. Then a retracement occurs. Then another move higher takes shape, which fails to exceed the previous high. Now you understand the first high is the left shoulder, the second high is the head, and the most recent high, which fails to exceed the head top, is considered the other shoulder. I would be concerned about the Dow if 7000 were broken.

Q: Do you think the market will break the last week's lows?

A: Odds right now for the S&P 500 over the next 15 trade days are slim, but realistic. Chances are probably only about 2 in 10 that we will get more than one close underneath 775. I expect prices to at least garner buying interest at 855-835 on the S&P 500. Additional bad headlines might force prices lower and cause this observation to be wrong. Worst case right now that I see, based upon my studies of price action after the kind of reversal we saw last Wednesday, would be a close for the S&P 500 at 800.


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