The Year Of The Rat

February 10, 2008

163

According to the Chinese Zodiac, February 7^th was the dawn of the Year of the Rat. The Rat is supposedly associated on the one hand with wealth, aggression and order and, on the other hand, with war, pestilence and atrocities. It is considered to be a year that yields rewards only after hard work and is associated with extremes and hence volatility.

In the month preceding the dawn of the Chinese year, the stock market was especially volatile and, with its advent last week, the pattern remained.

Dow Jones Industrial Average: >4% Decline [600+ point decline from week high to week low]

NASDAQ: > 4% Decline [150+ point decline from week high to week low]

S&P 500: > 4% Decline [75+ point decline from week high to week low]

Did it really feel like major market averages declined 4% this week? By the end of the week, the volatility index had climbed from 25 to 28, which frankly didn’t seem a lot given that on January 30^th (when the SPX closed almost flat after an intra-day move up 30+ points followed by a reversal of similar proportions), the VIX moved intra-day from 28 to 25 and back to 28 again. Perhaps traders were relatively complacent during last week’s slide as indicated by a comparatively low number of put purchases. If this is the case then it bodes ominously for the future and leads to the likelihood of continued and even more pronounced market undulations. Indeed during the week, Phil predicted that, within a month, we would see a 1000 point intra-day move in the Dow. Impossible? Don’t bet against it! On Thursday alone the Dow had a 680 point intra-day move, having gained 100 points, lost 100 points, gained 180 points, lost 180 points and finally, in the last hour before the bell rang, gained another 100 points!

The upcoming week begins with the news that Yahoo has rejected Microsoft’s $44Bn bid and Google has risen to its down-trending resistance line. On January 24^th I mentioned “if Google remains above $582 tomorrow, the likelihood is it will follow Baidu’s action with a reversal bullish. However, a failure of that level could signal a continued and pronounced trend lower…..tomorrow will be crucial for Google and the close is much more important than the open.” When the stock failed to maintain its intra-day highs of $594 and ended up closing below $570 the next leg down was clear; the stock subsequently dropped over $80. Google has bounced recently and so much of the previous commentary applies again, albeit with different price points. It will be a real positive to see the stock close above $513 but $520 would engender greater confidence. Intra-day action will be treated with skepticism until a convincing close is made above those levels.

With a backdrop of volatility, a market leader such as Google at a critical juncture (if it moves significantly so too will it move the market because of its large weighting!), and no major earnings reports (well unless you are a Baidu fan – reporting Feb 13^th) to catalyze imminent direction change, prudent risk management dictates reducing position sizing. Think about it this way… if you were previously comfortable placing 10 contracts on a position that used move $5 per day but now moves $8-$10 each day, you have subjected your virtual portfolio to much greater fluctuation. Unless you are comfortable with a significantly higher degree of account volatility, you should consider reducing your position sizes so that more volatile moves do not whipsaw your account unduly. Adapting to changing market conditions, cutting losses early and adhering to a system of trading is of paramount importance in this market environment.