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Potential Top

(March 24, 2002)

On Wednesday, we discussed the previous week's low of 10,501.90 and the possibility of a potential top with the Dow closing slightly below that level (10,501.57) on Wednesday afternoon. Since then, the Dow Industrials has even made a lower low (closing at 10,427 on Friday), with the Dow Transports confirming.

Because of this, we believe the Dow Industrials should now have topped. The only missing ingredient? Fear.

To gauge the current lack of fear in the market, we take a look at the following chart:

Correlation between the Dow Industrials and the VIX (June 1, 2001 to Present)

The VIX is an options premium indicator on the S&P 100 (OEX) or how much option writers are demanding for their willingness to sell these options to the retail investor. In other words, this gauges the overall fear of the market. If the option writers believe we are ready for a drop, then the VIX will go sky-high (e.g. take a look during the early parts of September). Conversely, if no one is anticipating a drop, then there is no demand for option protection, and option writers will be willing to demand a smaller premium in order to sell these options.

The current sentiment indicates a lack of fear. Since this bear market began in March 2000, a VIX below 20 has nearly always ensured a huge market decline within the next couple of months. We are at that juncture, once again.

While we believe the Dow Industrials has topped, this does not mean the market will crash 1,000 points tomorrow. When this bear market will resume, we believe, depends on the fear of investors. We believe for this to happen, the VIX needs to be in a clear uptrend. What will bring about this uptrend is a guess at best (we believe it will take a 200 + down day on the Dow but the trigger event will be a surprise), but in this current environment, there are lots of potential candidates (e.g. after the market closed on Friday, S&P downgraded Lucent's debt by two notches).

Unless a new bull market has started (which we don't believe to be the case), we believe the VIX is a great topping indicator of the markets. Based on the lower low in the Dow, we believe the Dow has topped and is now in a clear downtrend. How fast that downtrend will be will depend on the trend of the VIX.

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