Selloff Signals a Good Time for a Summer Break From Stocks

Earnings growth and interest rates could scarcely be friendlier for the market, so today's downdraft looks ominous indeed.
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Looking at it one way, what's happened on Wall Street today is not that huge a deal.

Sure, tech got blasted, but given how well it's done, is that such a big thing?

Microsoft

(MSFT) - Get Report

beats estimates but doesn't live up to the market's expectations that it would announce a tracking stock for its Internet holdings (which would end up with a capitalization of -- and this is really a number people were throwing around -- $70 billion), and it drops 5.1%. It's still up 9.8% for the past month. "We've had a nice run-up," says one tech trader. "You're not really losing out by selling a little Microsoft here."

But while that point of view may be getting play in some circles, in others there's real concern about what's going on. Three of the four biggest hitters in the

S&P 500

-- Microsoft,

IBM

(IBM) - Get Report

and

Lucent

(LU)

-- just reported numbers that bested estimates. Earnings across the board have been good, and it looks like the third-quarter will be even more of a blowout. The yield on the long bond -- one month ago at 6.17%, with talk of how it could go to 6.5% -- has come back down convincingly below 6%. Stocks are supposed to go higher when these things happen. Instead, they've gotten crushed, with the

Nasdaq Composite Index

down 3.5% on the day.

That's disconcerting. It's hard to reasonably imagine that the news on stocks can get much better than it's been. That third-quarter earnings growth will suddenly look like 25% rather than the 20% being forecast. Or that

Alan Greenspan

will, during his

Humphrey-Hawkins

testimony Thursday, give anything more bullish than the even-handed speech people expect.

There are other things that make it look like investors may have gotten a little overbullish. The

Market Volatility Index

, a measure of implied volatility in the options arena, Friday hit its lowest levels since the stock market topped out in July. Implied volatility is a measure of how volatile -- and you can safely replace "volatile" with "dangerous" -- the market is going to be. A low VIX suggests a high degree of complacency -- a market that's been priced for perfection.

"The sign of a top is when the VIX gets very low and rises," says Steve Shobin, chief technical analyst at

Lehman Brothers

. This, it turns out, is what the VIX has done.

Volatility Bottoms Out -- Spelling Trouble
Two-year performance of the Market Volatility Index

Source: BigCharts

"We've seen our highs," says Ronny Kraft, CEO of

Gotham Capital Management

, a New York hedge fund. "There are significant problems for this market on a fundamental basis, and it's on weak technical footing as well." Kraft thinks there's a chance the market will see a brief snapback from here, but he says it will "absolutely not" be this high by Labor Day.

Kraft is quite bearish on the market's prospects, calling for a 15% to 30% pullback on the major indices. But even less pessimistic types see little point in doing anything until September. With investment bankers and CEOs already at the beach and Europe about to close shop for the summer, it's unlikely that there's much good news for the market in August. In a market already priced for perfection, that magnifies the effect of bad news. A good time, according to Larry Rice, chief investment officer at

Josephthal

, for long-term investors to let the market shake things out a bit, and pack the kids into the car.

"Why take the risk of putting new money to work?" he says. "Raise a little cash and just go away. Go away until Labor Day."