What a Week: Much Worse Than Expected

Even if Motorola (MOT), Citigroup (C) and GE (GE) joined the disappointing parade and crude oil topped $68 by Friday, that didn't seem to justify the panicky selling Friday.

So what was different about Friday? It marked the expiration of January options, including long-term ones such as LEAPs (long-term equity anticipation securities), which brought the volume of option contracts to roughly 80 million, according to Chris Johnson, market strategist at Schaeffer's Investment Research "That's huge compared to normal," he says.

Option to Sell

Against popular opinion, the expiration of options normally reduces the volatility in the market, Johnson says, "unless it doesn't, and in that case it can multiply [the losses]." Friday was one of these days. As the expiration of options drew near, and the market opened with a negative bias, many owners of in-the-money options had to sell underlying shares to hedge their bets.

For example, Google (GOOG) closed at $436 on Thursday. As the expiration of January $430 put options (which give the owner the right to sell the underlying shares at $430) were only worth something to the holder if the shares were trading below $430, and would be at least neutral to the owner at that level. Google actually traded up to $440 within the first 30 minutes of trading Friday, and owners of the put options rushed to sell the common shares just to break even on their put positions.

The snowball effect downward was then the result of owners of call or put options hedging at different levels by selling more shares and "the broad market jumping in," Johnson says. The result: Google shares plunged $36, or 8.4%, their biggest one-day drop ever, to close at $399.

Among the other hints that there was no panic selling, there was no surge of flows into Treasury bonds, normally a safe haven in times of fear in the market. The benchmark 10-year Treasury bond gained 5/32 Friday while its yield, which moves inversely, dropped to 4.35%.

The automatic buying at the dips seen in previous sessions when the market came under pressure indicates that big institutions and traders remained in charge and will likely be in charge next week, Johnson says.

It is often said that for the market to really capitulate and undergo an extended correction, the enthusiastic presence of retail investors is first needed, telling the smart money that the market is now more unstable and vulnerable to panic attacks.

On that note as well, there's little to worry about. Retail investors have continued to shun U.S. mutual funds, with only $660 million of inflows this week, down from last week's $1.4 billion, according to Bank of America market strategist Thomas McManus.

The volatility seen earlier in the week led to more outflows of popular exchange-traded funds tracking the Dow, the S&P 500 and the Russell 1000, he notes.

All in all, there's even something healthy that can come out of this week's market selloff. Indisputably, market expectations after two solid weeks of rallying in January and going into earnings season were very lofty. "Now, the pullback has purged some of those overbought conditions," Johnson says.

According to Phil Dow, market strategist at RBC Dain Rauscher, the market can still rest on expectations that earnings will show double-digit growth in the fourth quarter, and perhaps some positive guidance here and there.

This week showed the more service-oriented side of U.S. business is not feeling much better about its prospects than the manufacturing side -- as was evident last week when Alcoa (AA) and DuPont's (DD) earnings and guidance disappointed.

That may certainly spell trouble down the road for the economy and the market.

But the much more short-term-oriented traders' market has its sight on the coming week. The good news, if buyers haven't been scared off their wits by Friday's action, is that the energy sector reports earnings next week. And most of the fourth-quarter earnings growth, few have mentioned, will come once again from that sector.

All in all, energy is expected to report earnings growth of 45% in the fourth quarter, according to Thomson First Call. Not coincidently, among rising sectors on Friday was the Philadelphia Oil Service Sector index, which rose 1.9% after Schlumberger (SLB) reported blowout numbers.

The energy sector is also the only one of the S&P 500 which so far has more positive earnings preannouncements than negative ones. Did I mention that oil closed above $68 per barrel?

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