Monday, February 26, 2007

The Correction Has Begun

On Monday, the Dow drooped for the 4th straight session. The correction has begun.

Since closing at 12,786.64 (an all-time high) on Feb. 20, the Dow has lost 154 points to its resting place today at the close of 12,632.26. Four straight losing days: a trend? Maybe, and at this point in time, likely.

There does not need to be any reason for a decline in the price of stocks as investors will make up any assortment of reasons to buy or sell, but when it comes to substantial increases or declines in the value of the blue chips of the Dow it's worth a second look.

On Monday, there were 16 Dow components in the losing column, one unchanged and 14 posting gains. The disparity was not large and neither was the point loss, a mere -15.22 for the session. Since the Dow is not a weighted average, a closer look at the components reveals that four of the five heaviest-traded issues were actually up.

Intel, the leader with 72 million shares traded, gained .09. Microsoft (63 mil.) was up .17. Citigroup (35 mil.) lost 1.09. Pfizer (32 mil.) gained .22 and General Electric (25 mil.) was up .24.

If the Dow was weighted, it would likely have shown a gain. But, it is not. The points are added and subtracted after being calculated by the Dow divisor, currently 0.14452124. So, that Citigroup loss of -1.09 ÷ 0.14452124 = -7.54. Citigroup's loss outweighed the gains of the other 4 stocks, even though those four stocks traded nearly 5 1/2 times the shares.

Adding a weighted average of the Dow might skew results to which investors have, over the years, grown accustomed, thus, it has not been changed in many years, though the divisor is routinely adjusted for splits.

So, we have the Dow in drop mode, while the other, weighted, indices march to their own beat. The finishes today were, however, similar. The NASDAQ lost 10.58 and the S&P was down 1.82. The reliably honest NYSE Composite showed a gain of just 1.24.

What we're witnessing and will be witness to over the next 5-7 weeks prior to the next round of earnings, is a bit of divergence between the indices. While the Dow and S&P should follow a similar path, I expect the NASDAQ, with its preponderance of tech and mid-cap issues, to outperform both of those.

Remember that in the dotcom implosion of 2000-2002, the NASDAQ took the most severe beating and has only recovered to less than half of its all-time high while the Dow has set new highs and the S&P is close to record territory. 1527.46 was the all-time high for the S&P. It's currently less than 80 points from that mark.

A 10% loss on the Dow would barely be noticeable. From its high of last week, a 10% decline would only put it at 11, 508. I believe a 15-20% loss on the Dow is now in the cards. It would signal to investors that the market is and has been overbought and that the colossal returns of the past 4 years cannot be sustained indefinitely.

I won't bore you with the details of my calculations, but note that Fibonaci numbers will be in play. Expect the Dow to bottom out around the 10,350 to 11,100 range. We're not in a position for a full-blown recession, but indications are that the economy is growing at a slow, sustainable rate. Dollars will be taken off the table in a combination of profit-taking and over-indulgent fears.

The entire episode should shake out by the end May, when the markets will likely go sideways for a while before setting sail for new highs in 2008. It's going to be a rough ride for a while, but nothing earth-shaking unless political machinations derail into some unlikely chaos.

The NASDAQ will fare much better, with an 8-10% decline being the absolute worst of this round.

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