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This week the market is able to grind higher. It has ignored turmoil in Egypt, a credit downgrade in Japan and higher interest rates in China. All of the pieces are in place for a big rally now that credit concerns have eased.
Corporate profits are up 35% year-over-year and the S&P 500 is trading at a forward P/E of 13. Bonds yields are low and now that confidence has been restored, money is shifting out of bonds and into equities. Investors are starting to pile back in now that the market is making new two-year highs.
The Fed continues to ease and it has its foot on the gas. President Obama is trying to lower corporate taxes and decrease regulations in an effort to stimulate capital investment. Economic conditions continue to improve and the new EU credit facility is gaining support. These are all “market friendly” events.
For six straight quarters, we have seen stocks pull back as earnings season tapers off. Optimism reaches an extreme level and stocks get priced for perfection. Bullish sentiment soars and option implied volatilities (VIX) collapse. These conditions are in place and we need to be mindful that a sharp correction that lasts a week or two is overdue. That selling could come from an interest rate spike, higher inflation, PIIGS bond auctions or spreading unrest in the Middle East. I don’t know what event will spark the profit-taking, but we are overdue.
Asset Managers are waiting for a pullback so that they can add positions. That means any decline will be short-lived. The bid to this market is strong. The weakness might simply come in the form of sideways price action while the market gathers strength.
Next week, the highlights will be retail earnings and inflation. These are fairly light news events and they have not weighed on the market in the past. Higher prices will be blamed on food and energy, but bulls will point to tame core inflation. This is the market’s interpretation, not my. The cost of living has been increasing at a very steady pace. My loaf of bread might cost the same as it did a few years ago, but I am spending thousands more on college tuition, health care and taxes (sales, property, and state income tax). Perhaps next week, the market will start paying attention to the PPI/CPI. Retail sales and retail earnings next week should be positive. Department stores have reported decent same-store sales and consumer spending rose .7%.
Because the market is due for a pullback, I am focusing on stocks that have declined to a support level. If the earnings and the guidance were strong, I am selling out of the money put spreads. It’s been difficult to resist the temptation of buying calls and I am long a handful of in the money calls. Even if we see selling pressure, my put spreads will be fine. On a pullback, I will buy calls once support is established.
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