Option Investor
Market Wrap

Seller Boycott

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       WE 11-12        WE 11-05        WE 10-29        WE 10-22 
DOW    10539.01 +151.47 10387.5 +360.07 10027.5 +269.66 -175.57 
Nasdaq  2085.34 + 46.40 2038.94 + 63.95 1974.99 + 59.85 +  3.64 
S&P-100  566.22 +  8.32  557.90 + 17.25  540.65 + 15.49 -  6.64 
S&P-500 1184.17 + 18.00 1166.17 + 35.97 1130.20 + 34.46 - 12.46 
W5000  11609.67 +200.13 11409.6 +340.64 11068.9 +320.91 - 90.63 
SOX      423.81 +  5.98  417.83 +  5.58  412.25 + 17.09 + 13.79 
RUT      621.98 + 17.69  604.29 + 20.50  583.79 + 16.02 -  0.65 
TRAN    3628.20 + 55.70 3572.50 + 75.08 3497.42 +125.48 + 19.26 
VXO       14.05           14.36           16.57           16.09 
VXN       18.82           19.47           21.90           21.36

Chalk up another big day for the bulls and new highs all around on the major indexes. Even the Dow almost made it across the major resistance zone at 10450-10550 without stopping. The SOX came back to life and there was not a bear to be found. It was not a rousing rally day but more of a slow creep upward with sellers nowhere to be found.

Dow Chart

Nasdaq Chart

After a government holiday the economic reports came back to haunt us with October retail sales posting a dismal +0.2% gain compared to a +1.6% gain in September. The biggest drag came from Autos at -2.2% for the month and surprisingly the building materials dealers at -1.1%. Apparently hurricane sales slowed slightly in October after a bounce in Sept. Ex-Autos the headline number would have been +0.9% but if you take out the spike in gasoline prices that number drops back to +0.5%. Any way you slice it sales were terrible and it appears consumers were constrained by the impending election and high gas prices. Wal-Mart claims their average ticket is $50 and the gas prices have taken $10 off that average. Apparel was the strongest sector at +3.0% as the first winter storms hit and drove consumers to the stores for coats and winter clothes.

The Consumer Sentiment came in much stronger than expected and could be telling us that holiday shopping is going to be strong. Sentiment rose to 95.5 for the first November reading and up from 91.7 in October. We know October was depressed by the election mudslinging and high oil and November has seen both of those problems go away. Both the expectations and current conditions components rose for the first half of the month. This was the first gain since July and the biggest gain since June. The strong jobs report also helped boost sentiment.

Business Inventories rose a paltry +0.1% for September and well below the +0.7% jump in August. Inventories are near historical lows in relation to sales and they are not likely to fall any further. Inventories were up +7.3% on a year over year basis. However, these very low levels of inventory will not contribute to the GDP effort. This is a sustenance level not a rebound level.

None of this negative news had any impact on stocks. Traders took one look at the Consumer Sentiment and weak oil prices and said we need more stocks. There was nobody around to sell them and the prices started higher. Prices appeared to languish over the lunch hour as they waited for the FOMC minutes from the September meeting but once the news hit the wires it was off to the races again.

The minutes expressed some concern about the pace of the expansion although they said it appeared resilient and self sustaining. The Fed saw solid growth ahead but at a pace that was less brisk than previously expected. They saw numerous risks to the downside and questioned the need to continue raising rates but still felt a "gradual" pace of increases would be all that was needed to maintain steady growth without inflation. The problems they were concerned about were primarily job creation and fading demand. Since this meeting we have seen a sharp jump in job growth and continued slow growth in demand but growth that is still rising. It is anticipated that the cautious Fed as evidenced by the minutes was probably not going to make any big moves and the "measured pace" phrase was going to continue into 2005. Estimates are for a rate hike in Dec and Feb and continued low inflation.

There is no shortage of consumer demand in the stock market. Schwab noted that there was a +16% rise in trade volume in October and November was even stronger. Ameritrade said November volume was up +20% so far. AMG Data said for the week ended Wednesday there was $4.3B in cash inflows to mutual funds. That was the biggest single week since April and tax month. Investors appear to be going for the gold into year end and worrying about 2005 when we get there. Earnings for Q3 are nearly done at +15.1% and guidance is light for Q4 and beyond. This entire rally is built on the hope that the 2005 outlook will change before we get there.

It is also built on relief. Relief that the election process is behind us and relief that the year long down trend appears to have been broken. Relief that oil prices have fallen -15% off their highs is also a factor. Would you have believed back in July that traders would be relieved that oil was ONLY $47.50 a barrel today? Oil was trading at $35.50 on June-30th.

Crude Oil Chart

Chart of US Dollar Index

Gold Chart

While the equity markets were setting new highs on nearly all the indexes the dollar was still getting knocked for a loss. This could grow to be a real problem soon and one that could cause the markets more stress than oil ever could. We are nowhere near a critical level but we need to keep it on the radar screen. The best way to prove the importance of the falling dollar is to simply look at gold prices. Gold closed at a sixteen year high on Friday at $438.30 and the dollar closed at an multiyear low. Deficits and trade gaps do matter.

The markets popped in their ear plugs and placed their tunnel vision glasses firmly in place. Once the sentiment was announced it was buy, buy, buy but it was not a feeding frenzy. Just a slow creep higher until the SPX stopped its advance at 1177 and waited for the FOMC minutes. Once the minutes were released and deemed bullish that SPX level broke and multiple buy programs tacked on another six points to close at 1183.44 and less than a point from the high of the day. Once that 2002 high at 1177 was broken the race was on and announcers could not say enough positive words about the rally.

SPX Chart

The Dow struggled to break over 10500 but once broken it nearly made it all the way across the 10450-10550 danger zone without stopping. This is a monster move and it has shown no signs of weakening. If the Dow can clear the 10550 level then the highs for the year at 10750 are the next target. Should we see a pullback initial support would be 10450.

The Nasdaq has literally caught fire over the last two days. The Dell bounce helped and even the SOX participated. The Nasdaq Comp closed near the high of the day at 2083 and 2100 is only a stones throw away. This is a huge breakout of +49 points from the Wednesday close. After trading perfectly sideways for four days the sellers failed to appear Thursday morning and the last two days were very strong. Investors finally decided chip stocks were undervalued and the SOX added +17 points over the last two days with a close well over the 420 resistance level. If the downtrend resistance at 425 can be broken like we have seen on the other indexes then the Nasdaq could really explode.

The Russell rambled to another all time high and closed at 622 and right on the last shred of resistance dating back to Jan-2004. I see no reason why this breakout should not continue other than the sheer magnitude of the rally. The small caps should continue leading and we should watch the Russell as the leading indicator of any potential pullback.

Russell Chart

SOX Chart

With the exception of the SOX all the indexes are now setting either new multi month, multi year or historic all time highs. Even the transports closed at a new five year high and the Dow utilities at a new three year high. Bullishness is not just breaking out all over but it is rampant and growing. It is reaching extreme levels but traders are scoffing at the idea of taking profits. Nobody wants to sell. Up volume on the S&P was nearly 4:1 over down volume and we are at severe nosebleed levels. Volume across all markets roared back from Thursday's holiday level and hit 4.3B shares. Advancers were better than 2:1 over decliners for the second day in a row.

Stronger volume, strong A/D and more than 10% of all stocks were trading at new 52-week highs. Sounds like the Goldilocks market for the bulls and the perfect storm for the bears. Those bears trying to short this rally have been road kill for two weeks now. Those trying to short are dwindling as the bull gains more and more converts.

There are two challenges now. The first for the bulls is the amount of extension we have seen. The Dow has risen +831 points, +8.6% in 14 trading days with no material profit taking. We have had a couple of minor losses but most profit taking came on days where there was a large move higher and then an afternoon sell off. There has not been any materially negative day. The S&P has only lost ground on four of the last 15 days and the total points lost was only -4.20 or an avg of -1.05 per day. This may not qualify as any kind of string but in the middle of that period it was positive for nine consecutive days. In short there has been NO profit taking and the risk is beginning to grow that some will appear soon. Very soon.

Conversely there is also risk to the upside, very strong risk. There is a general feeling starting to make the rounds that the current rally is the beginning of the second leg on a cyclical bull market that started back in March of 2003. If you remember we had a monster rally off the March lows that added +47% to the SPX and topped in March 2004. Since March we have trended down as the election mudslinging increased along with higher oil and a perceived terror risk for the election. All very normal reasons to consolidate. Now those worries are behind us the general consensus is a 1250 S&P target by year-end. However, that is just the first stop if you believe a growing analyst population that is now targeting 1350-1500 for year end 2005.

Dow Chart 1993-1995

Dow Chart 1995-1997

Dow Chart 2002-2004

I do not want to get into the dozens of reasons why those 2005 targets may be right or wrong because it does not matter for the next two weeks. What matters is the risk to the funds that those predictions could come true. If they are not fully invested for the rest of the year then they could miss out on another +10% S&P move to 1300. Why 1300? Because the obvious target of 1250 could be hit next week and there is a lot of year left. If you are a fund manager you can't afford to be wrong and waiting on the sidelines for the next pullback. It may never come or when it comes it may be so weak that you passed up on a +5% gain to get a -1% pullback.

The comments beginning to make the rounds since the last Jobs report suggest we could see a strong upward revision in 2005 guidance with the January earnings. Companies like Dell are not seeing any abnormal buying but they are seeing stronger demand than most people expected. The weak guidance for Q4 may result in a lot of better than expected earnings in January if the next two months continue to improve as dramatically as the last 30 days. Funds can't afford to be wrong. Being cautious is not an option at this point.

Analysts still claim there is a lot of money on the sidelines. The range bound down trending markets over the last ten months have punished attempts to get long several times and managers were either skeptical or caught under invested on the post election bounce. I have reported several times over the last couple months about the high cash positions in many funds. Some as much as 25% to 35%. We have to assume that most of these very large numbers have been shrunk to smaller levels of maybe 5-10% or less. With $7 trillion on deposit in mutual funds and $1.5 trillion in hedge funds even a minimal 3-5% can be a very large number. If the average mutual fund cash position was only 5% that would be $350 billion uninvested. At 3% that number drops to $210 billion and neither number takes the hedge funds into account. Remember I said average and many funds keep less than 1% in cash but many others could have a substantial cushion.

If these under invested funds do not participate in any continued rally then customers will move the money to a different fund next year. It is "buy or die" for any fund not currently fully invested. Add in all the retail money still hesitant to believe in the rally and you have a lot of reasons for the rally to continue.

What I am describing is not fundamental. It has nothing to do with earnings or the economy. It is survival of the fittest for funds and the battle has already begun. Logic would suggest there SHOULD be a pullback to consolidate our gains from the last three weeks. Logic rarely works in new bull and bear markets. Panic is the only emotion likely to be seen over the next two weeks.

If you are like me you are looking at the set of vertical green candles above and thinking the sky is about to fall. Nothing that vertical can last. In fact the current ramp has not yet reached the proportions of some recent rebounds.

Jul-2002 775 to 909 +17%, +134 points, five days
Oct-2002 768 to 900 +17%, +132 points, eight days
Mar-2003 788 to 896 +14%, +108 points, eight days
Oct-2004 1090 - 1184 +8%, + 94 points, fourteen days

As you can see our current spike, although appearing vertical to those if us who have been range bound for ten months, has been weaker than prior rebounds. This suggests there is room to run and any pullback could be limited at best. A run to 1250 from here would only be +66 points and another +5% gain.

For a true picture of the strength of the market compare the breakout in the Wilshire 5000 with the Dow. The Wilshire has clearly broken out and at three-year highs with plenty of room to run. 5000 stocks vs only 30.

Wilshire 5000 Chart

I hope I have not alienated anyone with this analysis and reporting of the current market rumblings. As in politics, religion and football there can be many opinions and all different. I only try to sift through the many available, weigh the options and present the likely outcome.

Imagine the market is like a football game. The bulls have the ball and have been marching down the field in pretty impressive fashion with the goal line at SPX 1250. The bears have been getting trampled on nearly every play. They know they are being pushed back nearer to their goal on each play and the situation is serious. As the time begins to expire on the November clock each play becomes more critical. They may eventually sack the bulls for a loss but more than likely the next play out of the huddle will be a long bomb for a bullish gain. The bears have no replacements and the walking wounded are getting weaker. The bulls on the other hand have legions of players just coming off the bench with pocketfuls of cash for padding. While the game may not be over the outcome is pretty obvious. We don't know how many plays are left to be run before the bulls score or how many sacks the bears may achieve. That is what keeps it interesting.

Next week the economic calendar increases in intensity but baring an absolute disaster it will be ignored. Buy any dip and don't count on them being deep. Watch for an interception and be prepared for high volatility. Keep your eye on the Russell for directional indications. It should be a fun week as option positions are squared ahead of expiration. Odds are very good there are a lot of traders with naked option positions that got away from them and they will have to buy to cover beginning on Monday. This should increase the upward pressure on the market. Max-pain for the SPX is 1125 and hopefully out of reach. Any move higher on Monday could start another serious short squeeze.

I realize I have painted a strongly bullish picture and one that may run contrary to logic. The market exists to confound the maximum number of traders at any given time and after crawling out on the limb today I am just begging for it to be cut off behind me. Trade what you see and you can't go wrong.

Sell Too Soon!

Jim Brown

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