Option Investor
Market Wrap

Kerry Wins!

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       WE 10-29        WE 10-22        WE 10-15        WE 10-08 
DOW    10027.47 +269.66 9757.81 -175.57 9933.38 -121.82 -137.45 
Nasdaq  1974.99 + 59.85 1915.14 +  3.64 1911.50 -  8.47 - 22.23 
S&P-100  540.65 + 15.49  525.16 -  6.64  531.80 -  6.67 -  4.64 
S&P-500 1130.20 + 34.46 1095.74 - 12.46 1108.20 - 13.94 -  9.36 
W5000  11068.95 +320.91 10748.0 - 90.63 10838.7 -125.85 - 94.18 
SOX      412.25 + 17.09  395.16 + 13.79  381.37 -  8.15 - 12.39 
RUT      583.79 + 16.02  567.77 -  0.65  569.42 -  6.23 -  9.38 
TRAN    3497.42 +125.48 3371.94 + 19.26 3352.68 + 16.68 + 37.20 
VXO       16.57           16.09           15.89           14.95 
VXN       21.90           21.36           21.80           20.69

The markets are predicting a Kerry victory but it depends on which market you are looking at. A normally dependable indicator says if the Dow falls in the three months prior to the election the challenger will win 81% of the time or 9 of the last 11 elections. The Dow lost -1.1% over the last three months. However, that is not the final word.

According to Forbes.com they have analyzed the trend using not only the Dow but based on the Nasdaq, 5 of 8 years, the S&P, 8 of 11 and an average of the three gave 8 of 11 correct predictions. The most accurate was based on the S&P gains minus the inflation rate as evidenced by the 90-day T bill. Using this indicator there has been a 91% success rate or correct predictions in 10 of 11 years. With the S&P up +2.5% for the last three months and the 90-day T bill at 0.40 the result is a +2.1% S&P indicator that says Bush will pull it out at the end. This indicator has a 91% track record of success. Now we know you can make any indicator predict anything if you apply enough qualifications. I would not bet the farm on this outcome. The electronic futures polls had the race exactly dead even at midday on Friday with each candidates futures contract worth $50.00. By days end they had separated to $52 Bush, $48 Kerry. The Real ClearPolitics.com average of all polls as of Friday night had Bush ahead by +2%. Bottom line it remains a dead even election and the lack of any market gains on Friday was probably more related to the lack of a clear leader than any other factor.

To further confuse the issue Jeremy Siegel, professor at Wharton, highlighted some election statistics on Friday. There have only been negative market returns over the last 100 years under three presidents. They were Hover, Nixon and Bush. We all understand why the economy under Bush has performed poorly with the 9/11 attack knocking 2.5 million jobs out of the economy and the Y2K bubble turning into a serious bear market and a recession. Neither event was his doing and he had no control over either. Also, in the last 100 years only TWO republicans have been unseated by a democratic challenger. Carter beat Ford and Clinton beat Bush. Siegel suggested it really did not matter to the markets now on who won this election just that it was behind us. I doubt he will find any objections from traders.

Nasdaq Chart

Dow Chart

SPX Chart

Friday was full of economic events and the overall news was very good for the economy. The opening salvo was the GDP at +3.7%, which was weaker than the +4.4% expected but better than the +3.3% number for Q2. The internals were significantly better than the headline number with consumer spending up +4.6%, business spending up +11.6% and business equipment up a whopping +14.9%. This was a very good report and the headline number would have been much better except for the high oil prices skewing the import numbers and the excessive inventory build in Q2 holding down additional inventory additions in Q3. Core inflation as measured by the PCE component rose only +0.7% for the quarter and at the lowest rate since 1962. This is a phenomenal number and allows the Fed to pause in the current rate hike cycle and watch for new economic clues in 2005.

Prior to today the expectations for the eventual rate level was something in the 3.0-3.5% range. After the GDP and some comments from Fed Vice Chairman Roger Ferguson that level is now drifting to the 2.5% range. This is a big drop in expectations and the market did not react to it on Friday probably due to the election cloud. Ferguson said "several aspects of the current outlook lead me to suspect that the return of the equilibrium real rate from its currently somewhat depressed level to its long-run value might plausibly be expected to be gradual and attenuated compared with historical experience." In English the rate hike pace could slow based on external conditions. He also said "I believe that the combined force of several factors restraining aggregate demand, would require a lower real rate than otherwise to avoid economic slack." These comments led analysts to believe the Fed was measuring its current policy of continued rate hikes against the low job growth, high oil and the potential impact on the struggling economy. Again, the market did not react to the slight policy shift and I believe it was the election cloud keeping traders from seeing the light.

Another clearly visible sign of strength returning to the economy was the Chicago PMI which soared to 68.5 and well above the consensus estimates of only 59.7. Anything over 50 represents an expansion and the jump to 68.5 pushed it to the highest reading since the 1980s. New orders rose +10 points to 79.4 and production soared +21 points to 79.7. Another good sign was a substantial inventory drop to 51.8 from 64.7 which indicates the need to ramp up the replenishment cycle. That was the lowest reading since April. This is a very strong report and suggests the ISM on Monday could also be very strong. The PMI is unique to the Chicago region but the ISM is a national view of the same components.

The NY NAPM continued to rise with a small move to 313.7 from 310.4 in September. The NY-NAPM was not as bullish as the Chicago PMI but still an improvement after 14 consecutive months of gains. The August 2003 number of 221.7 was the cycle low for this series and NY has been improving ever since. The only material change was a drop in the six month outlook from 60.0 to 50.0. This suggests the 2005 view is starting to fade.

Consumer Sentiment took an about face from the early reading for October and jumped to 91.7 from the drop to 87.5 on Oct-15th. The end of month rebound to 91.7 was still a drop from the September level at 94.2 but a big sigh of relief for analysts. Present and future conditions both jumped over four points in the final analysis.

For the coming week we have not only the election cloud but the closely watched ISM on Monday and the Jobs Report on Friday. The ISM will be the more critical report this time around simply for the election impact. Post election the Jobs report will have far less impact on the national scene and even a bad report could be beneficial for the markets. In theory a bad report helps push the Fed to the sidelines and keep rates lower for a longer period of time.

Just before the bell it was announced a new Bin Laden tape was on the way and bonds soared and a closing rebound was nipped in the bud. After the close the Al Qaeda leader appeared on camera in traditional attire and without any camo and no gun. The tape was not a cave shoot and was much better produced. It contained negative comments on both Kerry and Bush and references to the election. The tape warned of more 9/11 style attacks and claimed neither Bush or Kerry could keep America safe. The tape was not made available until after the equity markets closed and that blunted the impact but the campaigns quickly picked up on the opportunity to go on the offense against terrorism. Conventional wisdom suggests the tape could give an edge to Bush as he has the track record for pressing the attack against Al Qaeda. Some said the tape also may have given Bush the edge because Osama attacked Bush in much more detail and only mentioned Kerry. That direct attack could have a reverse effect of suggesting Bush has severely pressured Al Qaeda and voters could cheer his effort. There are far too many questions and the spin machines will be working overtime all weekend to influence voter opinion.

Oil prices took another dive off the high board and retreated all the way to $50 intraday before rebounding to close at $51.75. This -10% drop from the $55.65 high on Wednesday could have all the appearances of a break in the trend but we only have to look back to August when oil fell from $47 to $41 and analysts were all predicting $35 before the election. I have believed for several months we would see a pullback in prices after the terrorist risk to the election has passed. The profit taking this week allowed funds to take their gains off the table and shift back into stocks for their year end statements. I view any pullback in oil prices as buying opportunities for oil stocks but I would wait for the election to pass before jumping into new positions.

Analysts were pointing to oil as the catalyst for the gains in equities this week. I view that as strange since equities soared on Tuesday with oil at $55 and a day before the actual high in oil and the big profit taking drop. I do believe we could see a monster rally next week if we have a successful election with a clear winner on Wednesday and oil under $50. This would prompt further profit taking in oil and further strong asset allocation back into equities.

For the week the Dow gained a whopping +269 points, +317 if you count from the 9708 low on Monday. This is a very strong bounce and as I illustrated on Thursday night a historical trend for mutual funds to paint the tape for their year end on Oct-31st. Now that their year end is over we have two trading days left before the election is history. It will be a real test of market strength to see if we can hold our gains until the election results are known. The Osama tape should be somewhat forgotten by Monday and hopefully not a factor.

The Dow has rebounded to 10000 and held there for two days while the gains were consolidated and the October clock expired. I fear that after the end of October race to a milestone level which provided strong marketing copy for end of year statements that Monday could be not just a pause for the election event but a profit taking episode. After three weeks of heavy selling it may be too much to ask for the selling to be magically over. The economics were strong on Friday and they produced no gains despite the month end. We have seen it many times before in far less confusing situations where window dressing turned into undressing following a calendar crossing.

What could hold us up is the strong historical potential for a post election year end rally. November is the 2nd strongest month of the year behind December making the next 60 days very key to producing returns for funds. Even the very cautious funds cannot afford to be out of the market if a post election explosion occurs. Missing the first couple days of a rally typically takes 25% of the profit out of the eventual gains. Funds can't afford to guess wrong. If the Dow soared another +300 points before next Friday those out of the market would be in a very unsatisfactory position. They can't just place an order like you and I for a thousand shares each of ten stocks and call it a day. If a fund gets behind the curve and needs to buy millions of shares across dozens or even hundreds of stocks then prices go to the moon. It is the same as the cockroach theory. Where you see one there are probably dozens you don't see. When one fund is behind the curve there are likely dozens if not hundreds also behind the curve. For an example of funds behind the curve we only need to look at October 2002. The Dow rebounded off the 7200 bottom to hit 8540 in only eight days. Had you been flat at the bottom after two months of declines totaling nearly -2000 points the initial reaction to the first +400 point bounce in only two days would have been to expect a pullback from the oversold bounce. Unfortunately for those who waited there was no pullback and six days later the Dow was another +1000 points higher. This is a lesson that will not be soon forgotten by thousands of fund managers.

Dow Chart - October-2002

After reviewing the chart above it may put the +300 point bounce from this week into a different perspective. Instead of expecting a tape painting bounce to fail we may just see a pause for the election and a bookend rally to follow. This has been a terrible year for the markets and most funds are at basically a breakeven for the year if they did not play the oil rally. The SPX is only about 20 points away from where it began 2004 and the Dow is down about -425 points. The Nasdaq is nearing breakeven at 2003 and just hitting that goal will only make a new four month high. Funds need performance and this late in the year they are going for broke. Maybe that is a bad choice of words but you know what I mean. They have to load the boat with every available share and hope for a rising tide after Tuesday. They cannot afford for other funds to capture the gains and win the ratings race.

Conversely, should the market rocket fail to lift off the launching pad by the end of next week there is a serious danger of an implosion instead of an explosion. I would dare to bet that nearly 100% of traders expect a post election rally and should one not appear there could suddenly be some surprised bulls. Personally I think that Friday economics and a good ISM on Monday will set the stage for a pretty good run but there is always the possibility that all the bets have already been placed. Because the expectations of a post election rally are so strong anybody with money to invest should already be in the market. That only leaves those who were too afraid of an election event to chase the prices. Will it be enough to produce another Oct-2002 bounce? I really doubt it but until the market proves otherwise I suggest we remain long.

The bears are not without their rally points with strong resistance overhead on the SOX, Russell and the Wilshire. However, one strong day like we had last week and those bears would be racing to cover any shorts as those levels were broken. All really strong market rallies are built on the backs of disbelieving bears.

Wilshire Chart

SOX Chart

Russell Chart

The end of October tape painting left us with two days to ponder our fate and adjust positions before the election is over or at least until we hope it is over. I would look to buy any Monday dip and keep my stops tight until the election passes. At this point the market is past worrying over who will win the election and it more focused on just getting it over. Anybody placing an election bet based on a specific winner has already put their money on the line and we are just waiting for the dice to be rolled. Once past Tuesday the negative talk will be gone and sentiment, both market and consumer should improve. Earnings are over and the holiday spirit will begin building along with retail sales. It should be a great time to be in the markets but then disaster normally strikes when it is the most unexpected. Never assume and end of year rally is the only outcome. Hope for it, plan for it and bet on it but always keep an exit plan in place. The Dow and the Nasdaq are still in a long term down trend and until that trend breaks the risk for bulls is still high.

Enter Very Passively, Exit Very Aggressively!

Jim Brown


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