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Joel Addison, Optionetics.com
October 10, 2001

The stock market has recovered most of the losses incurred in the week following the terrorist attacks of September 11. In fact, one of the broadest measures of stock prices—the S&P 500 Index ($SPX)—is less than 2% from its pre-attack levels.  A number of sectors have been performing relatively well and investors appear to be looking beyond the short-term impact of the business disruptions and financial losses caused by the terrorist assault, and at the prospect of a profit recovery going forward.  However, while a few sectors of the market appear to be stabilizing, the earnings picture remains clouded and there may be a few more bumps in the road before the profit recession has definitely reached an end.   

One of the key factors driving stock prices lower for the past twelve months has been the ongoing profit woe within corporate America.  As is often the case, stocks turned lower before the actual earnings numbers turned negative.  The S&P 500, which measures the average share price of five hundred of the largest US companies, hit a peak during the third quarter 2000.  In that quarter, earnings for the S&P 500 were strong (18.3% higher than the year before). In other words, the S&P 500 companies were showing an earnings growth rate in excess of 18% when the market topped out. The S&P 500 earnings growth rate remained positive until the first quarter 2001.  By that time, SPX was already 24% below its September 2000 highs.  

Now, more than a year after the S&P 500 Index hit a peak, third quarter 2001 earnings reporting season is at hand.  In contrast to last year, rather than showing profit growth, according to the earnings-tracking firm First Call, earnings are expected to decline 21.3%.   In addition, profit growth has been negative during every earnings reporting period this year and are expected show declines again in the fourth quarter.  

Yet, as investors prepare for another grim earnings reporting season, the S&P 500 has been performing well.  So far this month, SPX is up nearly 4%.  The strength might be a sign that much of the bad news has been priced into the market.  After all, the forecasts and predictions regarding third quarter earnings have been negative for some time.  In other words, investors already knew that profit reports were going to be a disaster and sold shares before the actual earnings season was underway.  Now that the actual results are being posted, perhaps stock prices already reflect the bad news.  It’s similar to the concept of, “buy the rumor, sell the news.”  As an example, shares of Motorola (MOT) were unchanged on Wednesday despite news that it posted a $154 million loss in the quarter and the chipmaker will cut 7,000 jobs.  Indeed, much of the bad news appears to have been priced into the stock.

If the bad news has been discounted, going forward, the third quarter numbers are not likely to offer much guidance because investors have already priced in the worst-case scenario.  The more important information will be concerning the outlook going forward and the analyst reactions to what companies are saying about the fourth quarter of this year and the first quarter of next.  If analysts continue to hear earnings warnings regarding the next two quarters, earnings estimates will be forced down and stock prices are likely to remain volatile.

On that note, there appears reason to believe that estimates for the fourth quarter and next year’s first quarter will continue to come down.  According to First Call,

“Following the 911 attack, we had reduced our 4Q01 (fourth quarter 2001) expectations from a decline of 10% or maybe 15% to a decline of 15% to 20%. Given how fast 4Q01 estimates are coming down, it now seems likely that the decline will be closer to 20%, with a good chance of being worse than a 20% decline.”  In addition, estimates for the first quarter of next year are also coming down.  On September 10, first quarter 2002 S&P 500 earnings were expected to show 8.2% growth, now they are estimated to be unchanged from a very weak first quarter 2001.  In other words, show zero profit growth.  In addition, chances are, earnings in the first quarter of 2002 will show actual declines.  If so, the five consecutive quarters of earnings declines, will mark the worst period for corporate profits in more than thirty years.  It would equal the five down quarters during the 1969-70 recession.  

Therefore, while stock prices may rise when earnings results are reported over the next few weeks, the more important information concerns the next two quarters.  Investors are facing one of the worst profit recessions in history and there is a possibility that more bearish earnings news lie ahead.  If so, the result is likely to be more market turbulence and opportunities to make profits using non-directional option strategies that benefit from rising volatility, such as straddles.

S&P 500 Index ($SPX)
Statistics
Implied Volatility	32%
Historical Volatility: 50-day	24%
30-day	28%
20-day	32%
Put-Call Ratio (10/10/01)	.77
30-day Median Put Call	1.89
52-Week High	1,552.85
52-Week Low	944.75
Price (10/10/2001)	1,068.55
YTD Return	-19.1%
Average P/E Ratio	28.29
No. of Profitable Companies	NA
Number of Components	500
Type of Index	Market Value Weighted
Exercise Style	European

Over the past few weeks, Index Intelligence covered the following indices:

Date	Index	Ticker
08/13/01	S&P 500	$SPX
08/16/01	Dow Jones Industrial Average	$DJX
08/17/01	PHLX Semiconductor Index	$SOX
08/20/01	European-Style S&P 100	$OEX
08/22/01	AMEX Natural Gas Index	$XNG
08/23/01	Nasdaq 100 Index Trust	QQQ
08/24/01	AMEX Pharmaceutical Index	$DRG
08/27/01	PHLX Oil Service Index	$OSX
08/28/01	S&P Retail Store Index	$RLX
08/29/01	DJ Transportation Average	$DTX
08/30/01	PHLX Box-Maker Index	$BMX
08/31/01	Street.com Internet Index	$DOT
09/04/01	PHLX Utility Index	$UTY
09/6/01	Value and Growth	$SVX $SGX
09/10/01	S&P Chemical Index	$CEX
09/17/01	AMEX Airline Index	$XAL
09/18/01	Internet HOLDRS	HHH
09/19/01	AMEX Broker/Dealer Index	$XBD
09/20/01	AMEX Japan Index	$JPN
09/21/01	S&P 100	$OEX
09/24/01	AMEX Oil Index	$XOI
09/26/01	AMEX Disk Drive Index	$DDX
09/27/01	PHLX Gold and Silver Mining Index	$XAU
10/01/01	Mini-Nasdaq 100	$MNX
10/02/01	MS Cyclical Index	$CYC
10/03/01	Oil Service Holders	OIH
10/04/01	Russell Small Cap Index	$RUT
10/09/01	PHLX Bank Index	$BKX

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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