Cramer Rewrites 'How an Old Dow Learned New Tricks'

The trader explains the combination of factors that led to an unbelievable rally.
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The

Dow Jones

can still strut can't it? How does it happen, you might ask? How can a moribund market ignite for 800 points in two days?

(I waffled all week about which was the biggest story, the return of the traditional blue-chips or the decline of the Red Hots (now the TheStreet.com New Tech 30). But of course they're two sides of the same coin. People sold their traditionals to buy the new and when the new got too high and the old too cheap, they switched again. At least on the surface, that's what happened. But I find that kind of logic too seductive and too easy. It tells us nothing about why it happened and it's not predictive. I don't think the extremes in valuation, for example, told you anything, because the valuations have been extreme for a very long time. At any given point in time, we could have had this switch. In fact, for almost a year now, people had been predicting that it had to happen and it didn't. So what changed? Why this week? What was different? How can we spot it again? What triggered it? That's what this piece was about. I know I didn't read this piece anywhere else because it is borne of the trading trenches and could not be seen from 40,000 feet high.)

Good question! It isn't easy.

Let me explain the recipe that was required for such a massive effort. It was one part short squeeze,

(a short squeeze occurs when someone makes a bet against a market. Shorting is simply the mirror image of going long. If you think a stock is too high, you can sell it, then buy it back after it declines, and make the difference between the two prices. You can short anything: stocks, bonds, futures, options. We short stuff all of the time at Cramer Berkowitz. It's a necessary tool in a professional money manager's arsenal.)

as the trend has been to bet against the

S&P (the S&P 500 stocks are made up of stocks from dozens of industries, not just tech)

for more than a year now, with it accelerating in the last three months. It was one part buyback

(companies can stand at the New York Stock Exchange with open orders to buy back stock and they do it all the time)

, as many of the companies in the Dow have active buybacks because they think their stocks are cheap. It was one part pent-up demand for stocks with ridiculously low multiples, as money managers began to salivate at the prospect of leveraged buyouts and takeovers.

(This was the fundamental part of the story that the press harped on. It played a role, but as I said earlier, you might have thought it would have played a role long before this if you really believed that valuations were behind the move because valuations gave been wacky for years now.)

And it was one part March expiration, which historically has produced some wild moves.

(I took another stab at explaining expiration yesterday, with the baseball analogy. You might want to go there now.)

Each part played a role. You could never have this kind of move without all four parts, so let's explain the significance of each.

When a trend lasts for as long as the underperformance of the S&P, which trades similarly to the Dow in many ways, people get quite confident that the trend will continue. Even though there were studies which showed that the

Nasdaq

and the Dow had never diverged this much before, as long as that was the reality, people played it that way.

(I really have no use for theoreticians of the market. They make you no money. We are in a casino-like market and I want to game the casino. The absurdity of a Jeremy Siegel from Wharton coming out with some statement about valuation and how he thinks it's wrong is just poppycock. Valuation is what it is. If you could sell only thousands of dollars worth of stock at these prices, then I would be wrong. But you can sell trillions of dollars worth. So what does it matter if an academic says the prices are wrong. They are the prices. That is the hand you are dealt, so figure it out or get lost.)

The single best trade for the first part of this year was long

Nasdaq

,

(People can invest in the Nasdaq in a variety of ways. They can own the Nasdaq 100. They can buy the QQQs. They can buy calls on the QQQs. They can buy Nasdaq calls. )

, short

S&P

.

(They could be short individual stocks or they could short a basket of stocks that makes up the S&P or they can short the calls on the future.)

It generated a fabulous return and many people played it. (There was some rationale behind it, too, in that you could capture the earnings and revenue momentum of tech and hedge yourself against repeated

Fed

tightenings.)

(The biggest risk to the market by far was and is aggressive Fed tightening. But somewhere along the way we figured out that the tightenings hurt Old Economy stocks much more than New Economy ones. The Old Economy stocks rely on credit, which is getting more expensive, and need the gross domestic product to grow fast to make their numbers. New Economy stocks can tap the equity markets for capital and are growing at a much faster pace than the general economy.)

This was the money trade. That all unraveled this week when the two markets went, viciously, in the other direction. People who were short SPX calls or short SPX futures had to cover, frantically. The door was too small, though, because, once these stocks took off, real buyers emerged of the underlying equities, forcing the futures and calls on the futures ever higher. That led to a massive short squeeze of the largest stock market on earth.

(A short squeeze can occur in a small unit action -- the battle of the Hewlett-Packard (HWP) March 130 calls, or in a massive set piece battle, over an entire index. At any given level for a stock, there are buyers and sellers. Some of those buyers are buying to bring in a short sale, some of the sellers are selling to bet against the stock. So, if you are short Hewlett-Packard March 130 calls, you don't want that stock going through 130 on Friday because on Monday those in-the-money calls will turn into a short position in HWP common. How does that work? A call is the right to own common. The guy who has a call that finishes in the money is going to exercise that call and take delivery of the stock. Where do you think he gets that stock? You, who sold the call, give it to him. Your short call becomes short common. People short calls mostly to pick up income. Some short calls as a bet, though, against the market. Whatever, when the market ramps or individual stocks ramp suddenly, as Hot Water Pipe (the nickname for HWP) did after it said business was strong, you have to worry if you are short a call. You can buy the call back or buy common stock and not have to worry about being short the call, because the common stock you buy will serve to cover the short call that turns into short common. But occasionally there are so many people betting against a call, and so many people betting against the index that contains the stock with the call you shorted, that you get a whoosh, where the buyers panic. Real buyers come in, making it even harder to maneuver. The result is a short squeeze in the stock market that can exacerbate the small unit fight over HWP. This week people who had been selling SPX calls, which always have a tremendous amount of premium, found out that the SPX really can ramp, causing them to rush to buy these calls back before the losses became infinite. These two pressures, individual stock short squeezes and market short squeezes, probably had more to do with the 800-point ramp in the Dow than any other factor, which is why I spent so much time on them this week.)

It helped that, once the stocks started moving, the companies themselves stepped in to backstop the stocks. Companies can't move stocks up but they can ratify the movements by sticking big bids in once stocks have moved. So when

Merck

(MRK) - Get Report

is up four, Merck can be in there bidding and supporting the stock. As these blue-chip stocks moved up, the buybacks followed, making for a stronger market than we thought.

(You know when you see these giant buybacks announced, and then nothing happens? That's because most buybacks are done as a percentage of the volume. Nobody wants her company's buyback to be finished on the first day of the buyback. You have to spread these billion-share buybacks around. Occasionally, though, execs really turn on the jets and tell the buybackers to get real, and get some stock in. In the last few weeks, as the traditional stocks with huge cash flow came tumbling down, many of the execs at these companies decided to step up their buybacks. That eliminated a lot of marginal sellers. The buybacks also followed the stocks wherever they were. When they were down, the buybacks helped add stability. And when the stocks went up, the buybacks helped ratify the new levels. The most important thing they did, though, was take out supply. That meant nothing until real buyers came in. But if you look at Merck between the prices of $60 to $65, you'll see that it flew up with very, very little volume. That's because there was no supply between $60 and $64 and tons of demand. This would not have occurred if the company had been less active in its buyback.)

Meanwhile, the fundamentals, which may not be so hot if the Fed tightens, weren't so bad either. I think an article in last week's

Journal

about how airlines and other companies will begin to do leveraged buyouts if their stocks fall any lower really helped, as did the proxy for these stocks,

Warren Buffett's

fund, when Buffett suggested that he might buy back his own stock.

(People started talking about how, at these levels, the cash flows at some of these companies would be worth owning lock, stock and barrel. In other words, that if a company could get a loan from a bank, it could go buy all of its shares and go private. This had credence after the shellacking some of these industrial companies have had.)

The jarring realization that there were no

Procters

(PG) - Get Report

after Procter (except

Dial

(DL) - Get Report

) also emboldened people.

(We didn't have a spate of preannouncements this week in consumer stocks, so people felt pretty good about them.)

But none of this would have mattered if it weren't expiration week. Companies and hedge funds and individuals had grown complacent about shorting call options to pick up extra income on individual stocks as the stocks stood still. Up until a week ago this was another fantastic strategy.

That all ended this week. Stocks blew through strikes one after another, causing some horrific short squeezes as people tried to bring in calls that had dwindled down and ended up having to buy common stock to protect themselves from losing their positions.

(To blow through a strike means that a stock goes through one of the levels where options are sold. It takes a very powerful move indeed to blow through a strike, because so many people are betting against it. Back to Hewlett-Packard. Let's say that I like HWP. I buy the March 130 calls. When the stock gets to 131, I might want to turn seller of HWP common against those calls. That causes sell pressure. An out-of-the-money call that turns in the money brings in supply. That supply is usually more than a stock can handle. (If you are really confused by this, go to the Best of Cramer, where I have written about this repeatedly.) Now, because people know this supply affect, they tend to want to sell stock themselves at these levels, making a stock even heavier. You'll often notice that stocks get trapped or pinned by the strike. That's because of all the option pressure. So many people have picked up on this pattern that they eagerly short calls around strikes, betting they'll go out worthless. They almost always do. But sometimes you get a 100- year storm that upsets all of the statistical probabilities. We got that this week, and people who sold these calls got crushed in a vicious squeeze, which really intensified the upward move. Sure, real buyers came in, but all of these mechanics greatly increased the dimensions of the move.)

The combination of all of these led to an unbelievable rally that, I think, may be a harbinger of a level of volatility that nobody can even dream of.

In other words, maybe we haven't seen anything yet.

(I remain bullish.)

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long Hewlett-Packard. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

jjcletters@thestreet.com.