Prepare for the Wild Ride Ahead

December 21, 2001

With the changing of a New Year come the changing of the cycles, and based on current cycle configurations Year 2002 will visit Wall Street with unprecedented devastation and financial chaos. Foremost among considerations for the coming year are the declining 2-year, 4-year, 6-year, and 12-year cycles, along with the master trading cycle and even the K-wave itself, which is due to bottom in 2004. The even-numbered years typically prove the most bearish and Year 2002 will be without doubt the most bearish year since the Great Depression.

Pertinent to the stock market's current action and changing direction are the words of one astute observer, "Another thought to keep in mind in trying to 'rationalize' the market is that it may just be going up because of the triple witch options expiration. The crash low was on the last triple witch and it's possible that huge short baskets of stocks were put on and remain trapped short up until December 21st. The bulls will love to say it's the economy, but it could just be options leverage. The last breakdown didn't really get going until after the June triple witch so it is a factor to consider and that could give us a big March '02 low for the next triple witch. The effect of the leverage of these expirations has been quite evident the last few years if you look at the charts.

There have been clear three-month and six-month highs and lows on exact anniversary dates that are near the expirations. I think in the future with the advent of the new single-stock futures contracts starting in January, we will see a lot of three month up and down cycles and the market will become exclusively trading oriented." This reference to the coming single stock futures, the subject of much controversy, brought to mind something we recall reading in Ted Warren's famous book, "How to Make the Stock Market Make Money for You." Mr. Warren wrote concerning the futures market, "Brokers and advisory services, and of course the exchanges themselves, are quick to defend the futures markets' existence. These defenders of the legitimacy of speculating in futures claim it is necessary. The futures markets were created so that business firms and dealers in commodities can hedge against their stock in trade in order to protect them from wide changes in prices. The fact is that if there wasn't excessive speculation, there would be only moderate price changes." He added, "Could anyone be naïve enough to believe that the real reason for our futures markets is to take advantage of the human weakness for gambling? Well I am."

These timeless comments on the futures market underscore a point we would make concerning the advent of single-stock futures, viz., once single stock futures are introduced and begin to be actively traded it will not only cause the cycles to bottom more emphatically than they already do (due to expirations, etc.) but it will cause more volatility and amplitude potential (upside and downside) in the equities markets. It also serves to blue the distinguishing line between securities and commodity futures contracts and will ensure the two entities combine forces in order to hasten our nation's demise into runaway deflation. (As an aside we have always noticed the extreme similarity between the dominant cycles governing most commodities and those governing equities. This only confirms our assumption that the same cycles govern both). It is our opinion that single stock futures contracts are a bad idea and they could not have been introduced at a worse time. As the U.S. stock market prepares to plumb the bottomless depths created by the crashing 2-year, 4-year, 6-year, 12-year, 54-year and 60-year cycles (not to mention the dominant interim trading cycles), the way has now been paved for greater downside potential across the board next year. Single-stock futures were authorized by the Commodity Futures Modernization Act of 2000 (CFMA), which lifts the 18-year ban on single stock futures and narrow-based security indices (security futures). How interesting it is that this 18-year ban was exactly within the space of the Dow's 18-year broad-based bull market and that its lifting took place precisely as the Dow peaked. This has the markings of a bear market machination.

Back during the mini-crash of late 1998, an article was published in the Wall Street Journal about an obscure options strategy that was making a comeback at that time due to the extremely bearish nature of the market. Known as the "bullet," the trading strategy allowed investors to bet on a stock's decline even if the stock was caught in a free-fall. The strategy, which involves a complicated trading technique called "married puts," is especially alluring in a volatile market because it allows the traders to sidestep rules that prevent short sales when the stock's share price is already falling steadily.

Married puts involve the tandem purchase of stocks and put options. This combination allows the trader to sell the stock, leaving him with a bearish bet in the form of the put, without regard to upticks because the stock sales isn't literally a short sale. The trades are called "bullets" for a reason. Typically, they involve a rapid-fire sale of stock that is designed to build on a wave of selling that has already hit a stock. Even though the trader may be selling the married-put stock at a loss, the theory is that he will make an even bigger profit on the put option as its value rises based partly on the market impact of the aggressive stock selling.

For instance, the stock component of a married put is often sold with an "at market, not held" order, meaning the broker has been instructed to sell at every opportunity, rather than holding out for a particular price or easing the stock into the market gradually as buyers materialize at the lower price levels. Married puts significantly add to the volatility of some stocks, especially those that have been the subject of rumors and could be carried lower by a wave of selling that looks panicky. Question: will single-stock futures be any different in its overall impact in a down market? Probably not; in fact, it will only add to the downside potential. At that time in 1998, Edward Kwalwasser, group executive vice president of the New York Stock Exchange, said, "We look to see if anyone is manipulating our markets and if we see any violations, we are prepared to move forward aggressively." Well here's a heads-up tip, Mr. Kwalwasser. You and your colleagues at the Big Board are going to have your hands full in 2002 chasing manipulators.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including most recently “2014: America’s Date With Destiny.” For more information visit www.clifdroke.com.

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