Looking for the Why in the Whiplash

We've seen this movie before -- where stocks tumble precipitously only to mount a remarkable comeback by day's end. But there was something different about today's session, at least in terms of the magnitude of the decline and subsequent reversal.

After trading as low as 8244.87 -- its lowest level since Sept. 24 and down more than 400 points for the day -- the Dow Jones Industrial Average recovered to close down a relatively paltry 0.5% to 8639.47. Similarly, the S&P 500 lost 0.4% to 917.85 vs. its earlier low of 876.46, its lowest level since October 1997. The Nasdaq Composite, the relatively strongest performer throughout the session, closed up 0.6% to 1382.11 vs. its nadir of 1315.30, its lowest since May 1997.

Early on, the market was dragged down by the tumbling greenback, which revisited parity with the euro for the first time since February 2000 and hit its lowest levels vs. the yen since September. Additionally, shares proved unable to respond to potentially positive news, including: Pfizer's (PFE) buyout bid for Pharmacia (PHA), and positive earnings reports from firms such as Fannie Mae (FNM).

Myriad theories abound to explain the market's turnaround, which began in earnest at about 2:45 p.m. EDT:

This is it!: For some time, market participants have been eagerly looking for signs of capitulation signaling the selling had reached critical. At their respective peaks today, the VIX was at 43.76, the one-day Arms Index was at 3.25, and the CBOE's equity put/call ratio was at 1.02. In addition to those sentiment indicators, market participants noted selling in stocks that had previously been strong, evidence of a "throw the baby out with the bathwater" mentality among traders.

"I don't think this is the capitulation, but I do think there are some instances where we are seeing shares react illogically," said Brett Gallagher, head of U.S. equities for Julius Baer Asset Management, which oversees some $3.85 billion. "Companies that have held up relatively well are getting whacked just because the valuation gap between them and the rest of market has widened."

Gallagher mentioned Darden Restaurants (DRI), which fell 1.4% to $21.15 after trading as low as $19.25, as an example, but the trend was evident in a number of group that have previously been strong, including homebuilders, small-cap shares, gold miners, and defense industry participants. Julius Baer is long Darden.

Passing the Test: As noted above, the Dow dove today to its lowest levels since Sept. 24 and bottomed just above its Sept. 21 closing low of 8235.81. Some technicians were encouraged by the fact the Dow didn't fall below those levels. Still, as noted here previously, the recent history of the S&P, Comp, and myriad sector indices has been of a successful test of Sept. 21 lows only to subsequently revisit and tumble below them. The implication being today wasn't the Dow's "final exam."

It's the Pits: There were reports of huge program trading buys in the equity futures pit in Chicago. The buying boosts the futures markets, which causes short-sellers to cover positions, which helps push the market higher still, prompting move covering, etc. As with past episodes of big market reversals, the Federal Reserve was rumored to be the buyer, although there's scant proof. There were also rumors of a possible Fed ease. A more likely theory is that traders looked ahead to tomorrow's congressional testimony by Fed chairman Alan Greenspan and figured he might try to jawbone the markets higher.

Do the Wave: Devotes of Fibonacci wave theory noted that at today's low of 876.46, the S&P 500 produced a 50% retracement of the gains registered from its October 1987 low of 216 to its March 2000 high of 1534. (Here's the math: 1534-216= 1318; 50% of which is 659. Subtract 659 from 1534 equals 875.) Fibonacci retracements (named after a medieval Italian mathematician) describe the tendency of trend patterns in stocks (among other things) to reverse paths after they cross certain charted points.

That retracement, in conjunction with today's reversal, might suggest the third wave of the market's five-wave decline from its March highs has ended, suggested Steve Hochberg, co-editor of the Elliot Wave Financial Forecast in Atlanta. Regular readers will recall that Hochberg dismissed any "bottom" talk back on June 18, citing that third wave which he called the longest and strongest of the five.

"I do think we're ending that third wave now," he said today, suggesting there might be a little more downside but that today could produce a number of "selling climaxes." These occur when a stock or average hits a 52-week low but closes higher on a weekly basis. Of course, that presumes more gains for the rest of the week, but the Nasdaq's relative outperformance is "signaling we're coming into some sort of low," he said. "Things are dropping into place."

Still, Hochberg doesn't believe the final low has been established, forecasting the next (fourth) wave will take averages solidly higher for the next few weeks but that the resulting fifth wave will produce yet still lower lows. "Then you set up a big low later this year going in to next year," he said.

Of course, some observers fret that the market will have trouble making much headway near term given the Aug. 14 deadline for CEOs and CFOs to sign off on their firms' accounting.

"You'll see another wave of negative headlines between now and mid-August," forecast Julius Baer's Gallagher. "We're identifying companies here that represent attractive entry points," he said, naming Duke Energy (DUK) as an example (Julius Baer doesn't own Duke, which fell 4.2% on news it received subpoenas from federal agencies regarding its energy trading unit). "But we're not stepping in and buying because the market overall still has to go lower."

Gallagher observed that equity valuations remain higher than at any point in history before 1997: Much of the recent selling is "a reflection of how high up we went vs. how far down we're trading," he said. "We're not at bargain basement levels."

Even some heretofore optimistic observers are wary about recommending aggressive buying here.

"Typically, when stocks are this undervalued [relative to Treasuries], you want to own them," Ed Yardeni, chief investment strategist at Prudential Securities, commented today. "But I think we have to hold off for a couple of dates," including Aug. 14 and the anniversary of the Sept. 11 attacks. Also, there's the possibility of a military action against Iraq, Yardeni added. "And with regards to the accounting scandals, we think there are more coming."

Still, many previously bearish forecasters believe the time it at hand for investors to put money back into stocks. As reported earlier, Thomas McManus of Banc of America Securities raised his recommended equity allocation to 60% from 55% today.

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