The Coming Week: Intense Search for a Bottom Ahead

Forget greed. Fear is good.

Fear is the thing that shakes the weak holders, the seekers of quick profit, the Johnnies-come-lately out of the market. Look at where the market touched bottom in 1998, 1997, 1987, and there it is, at the fever pitch.

And who is to say that's not what we saw Friday, as the Dow and the Nasdaq lurched into their final, terrible hour? Spreads between bids and asks widened and volume dried up. The Chicago Board Options Exchange Market Volatility Index, a good gauge of investor worry, surged to levels not seen since October 1998. Earlier in the week, traders had griped that there was too much investor complacency over the decline. By the time the closing bell rang Friday, the traders weren't saying that anymore.

A Spike of Worry The CBOE Market Volatility Index, at five-minute increments

But the problem with fear is that there can always be more of it, and that there will be more of it seems as much of a characteristic of cataclysmic selloffs as anything. When the stoic start selling, when the last dip-buyer gives up -- then it turns. The problem is that everybody -- your broker, your dentist, your friend next door -- knows that. And that's worrisome.

"It was pretty dramatic, but it's still orderly," said Seaport Securities trader Ted Weisberg, as he left the New York Stock Exchange Friday. "I've been trading on this floor for 31 years -- 1987 felt much more dramatic."

"This wasn't as bad as last Tuesday," commented another floor trader. "It didn't seem to have the same pressure on it. Here, it was like, turn around, and you're just down another 100 points. Tuesday felt like a lot of pressure."

So it is hard to say what the coming week will look like. It is hard to say whether the bottom has been touched or, if it has not, how far there is to go. Maybe the only thing one can say is that if stocks haven't hit it, the bottom is coming soon.

"Chronologically, we're getting close to as bad as it's going to get," said John Manley, portfolio strategist at Salomon Smith Barney. Point-wise, however, it's hard to even venture a guess.

But Manley does believe the market has reached a point where investors have thrown the baby out with the bath water. On the Nasdaq Stock Market, the average stock is more the 45% below its 52-week high. That hasn't happened since 1987.

"I find myself in a very strange position," he said. "Three months ago, I was trying to defend the position that there were growth areas outside of tech and communications. Now I'm defending tech and communications."

Yet not everyone is so sure. Chartists note that there is very little support on the Nasdaq Composite, and it is hard to see exactly where investors will pick them up on a valuation basis. This is not to say that some of these stocks may not be fundamentally sound buys at current levels, but many of the newfangled valuation methods that some analysts were pushing have been discredited by the market's freefall, and under older methods there is a good deal more downside.

And there are other worries as well.

"I think the initial reaction has been that this is probably just a technical and valuation issue," said Rich Bernstein, chief quantitative strategist at Merrill Lynch. "Nobody wants to really say there are any fundamental issues in the technology sector. I think that's wrong."

Yes, There's More Tightening Ahead

And the chief fundamental issue may be that it looks like the Federal Reserve will continue to tighten -- never mind what has happened to the stock market. Friday's strong Consumer Price Index only reinforced that.

"The risks of a more aggressive tightening pace have risen given not just the CPI, but a variety of evidence that suggests inflation is creeping higher," said Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter. "My feeling is they're still going to stick to the gradual pace, leaving the door open for further moves."

As for the wealth effect, the degree to which the Fed believes U.S. consumption has increased due to asset price appreciation, it is unlikely that the selloff in stocks has done much to change that.

"Wealth effects accumulate over time," said Berner. "And given the breadth and depth of the increase in wealth, it's going to take a prolonged downturn in the stock market to reverse a lot of that." Though Berner does note that it is hard to gauge what the psychological impact of the drop in the market has done to confidence, even if it does make the consumer less buoyant, the economy is growing at such a quick pace that it is doubtful that it could slow of its own accord. Bit by bit, the Fed will keep on hiking.

That may be a hard thing for investors to deal with. Bernstein's colleague at Merrill, equity derivatives analyst Steve Kim, talks about something he calls the "Greenspan put." When the market crashed in 1987, during the savings-and-loan crisis of the late '80s, during the Mexican peso crisis in 1994, and again in October 1998, the Federal Reserve lowered rates. It was as if the Fed were writing free put options to protect investors on the downside. Investors may have gotten used to getting bailed out, and seeing the Fed's apparent penchant to raise rates despite the selloff may come as a surprise.

"How do you discredit the Greenspan put?" asks Bernstein. "Well, we're going to see it. Because he's going to tighten." And as he tightens, the economy will slow. And as that happens, the consumer will become less ebullient. And tech companies, thinks Bernstein, which not too long ago were supposedly immune to interest rates, will see their earnings growth slow.

But despite his bearish posturing on tech, Bernstein does not believe the end is nigh, joking that people who once criticized him for being to negative will probably start saying he's too positive.

"I don't think this is going to be as calamitous as people think," he said.

Let's hope he's right.

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