What a Week: Much Worse Than Expected

Friday's rout dispels talk of Dow 11,000, ending a week that punished fans of large-cap growth.
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So much for the call of many Wall Street strategists that 2006 marks the return of large-cap growth stocks. A Friday bloodbath punctuated a volatile week marked by disappointing earnings from high-profile tech leaders.

In the second week of the year, the talk was all about how the

Dow Jones Industrial Average

would finally top 11,000. But now, only one week later, the Dow has lost all of the gains it had made in January and then some.

The tech-heavy

Nasdaq Composite

and the

S&P 500

have kept some of their year-to-date gains, but they did not escape unscathed after three out of four sessions saw losses, including heavy selling on Friday. The week was shortened (mercifully for bulls, it turned out) by the Martin Luther King holiday on Monday.

Most of the damage occurred Friday, when the Dow dropped 213 points, or 2%, to 10,667. It was the Dow's biggest one-day drop since March 2003 and left the blue-chip index down 3.4% from a four-and-a-half year high of 11,043, reached on Jan 11.

Bigger losses were seen on the Nasdaq, which dropped 54.11 points, or 2.35%, to 2247.70 Friday. The tech-heavy index has fallen 3.6% from its Jan. 11 high of 2331.

The S&P 500 fell 23.55 points, or 1.83%, to 1261.49. The broad index is down 2.5% from its Jan 11 high 1294.

For the week, the blue-chip index lost 2.7%, the Nasdaq dipped 3% and the S&P fell 2%.

Obvious culprits for the bloodbath:

Disappointing earnings from high-profile companies that didn't meet Wall Street's lofty expectations.

Geopolitical tensions centered around Iran's nuclear ambitions, turmoil in Nigeria and new threats from Osama bin Laden, which all conspired to send crude oil prices above $68 per barrel.

Friday seemed to embody the doomsday scenarios about rising oil prices causing a slowing economy and slowing profits, as well as the ancillary threat of the cooling housing market.

But while these scenarios may eventually all play out, the evidence at hand seems to suggest that Friday was not the beginning of the end. The market came under pressure on Tuesday and Wednesday, amid disappointing earnings from most of the heavy guns of the tech world, including

Intel

(INTC) - Get Report

,

Apple

(AAPL) - Get Report

,

Yahoo!

(YHOO)

and

eBay

(EABY)

. Crude oil prices were already surging, but market participants still showed a willingness to buy the dips, starting Wednesday afternoon and carrying through Thursday's session.

Even if

Motorola

(MOT)

,

Citigroup

(C) - Get Report

and

GE

(GE) - Get Report

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) - Get Report

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) - Get Report

and

DuPont's

(DD) - Get Report

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) - Get Report

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?

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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