THEME: MARKET PARADOX: WHY THIS MARKET IS SO DIFFICULT

The market sentiment is littered with adjectives such as "frustrating." Traders seem to be unable to come to grips with this market.

One basic paradox for the market is if the market is charging a large terror premium, then why is volatility (the price of insurance) for the S&P at multi-year lows?

Check out these quotes:

Friday's action came in a market that remains vastly oversold, according to Edgar Peters, chief investment officer at Pan Agora.

Peters said he understands the uneasiness over high oil prices, but he says the market appears to be concerned about the risk of some terrorist incident ahead of the presidential election in November.

"The market is building in an exceptionally large risk premium for some sort of catastrophic event possibly before the election because based on our models, earnings would have to drop 35 percent in order to justify current levels, which is worse than the Great Depression."

From Donald Luskin:

THERE HAS BEEN a stock-market crash this year. You didn't know that? That's because it's invisible.

Think about this: So far in 2004, earnings for the S&P 500 have grown by 19%. Yet as of Thursday's close, the S&P 500 is virtually unchanged, having fallen by 1/3 of one percent before considering dividends.

With earnings up by that astonishing amount in just nine months, and the market unchanged — that's a crash. But it's not a crash you can measure in prices. It's a crash you have to measure in value. That's why it's invisible. But it's still very real.

All else equal, with earnings up 19%, the market should also be up by 19%. In fact, I think the market should be up even more than that, because at year-end 2003, stocks were already cheap.

Put it all together, and stocks are so cheap now that my valuation model says that the S&P 500 could rise by almost 35% from here and still be only fairly valued. Over the last 20 years there have been only three times when the market was as cheap as it is today — November 1988, October 2002 and March 2003. Every one of those three times was a terrific buying opportunity.

I think the market is struggling with what is fundamentally a problem of semantics. We invent names for things that we see as new. What we are experiencing right now is new enough that such labels as "inflation" vs. "deflation" just don't cut it.

There are good things going on in the market to be sure. Earnings are on the balance stronger, and balance sheets are stronger. GDP is quite strong and inflation is low. However, we see that terror hangs over the market and there is a general loathing that remains from the bear market. Fannie Mae's 13% decline in the past 3 days is reminding us that the days of Enron may not be over.

So, the market remains stuck. Good balances bad. China is inflationary and deflationary at the same time. Oil is up, but housing is up, too.

There is one hope for the long volatility players and that is for the Election to throw a surprise at us. I think that November will be a dangerous month. If terrorists cared enough to affect the Spanish election, then why should they not care about the US Election?

Here is one scenario that I have been working on: oil continues to rally all the way up to the Election, and then collapses after it. This collapse should send stocks higher. I continue to monitor this case.

THEME: BEHEADINGS & BEARISHNESS
Today's sell-off is a bit of mystery. Sentiment has shifted to fear. Volumes are not great. The ten year broke 4%. Fannie Mae may be a fraud. Oil keeps going up. The beheadings in Iraq (and murders of Italian women) are just too brutal for words.

We are on a knife's edge.

I think that the market will have an attempt at a rally. If it rallies in the morning then selling longs and hedging is the right response. The stronger the apparent rally and earlier it is, the worse the sell off will be in the afternoon.

What the market is sensing is that the enemy is being underestimated yet once again. Al Qaeda influenced the Spanish election. Surely, they have plans to disrupt this one. Does horrific brutality benefit Bush? Not if we start blaming him for all of this mess. And it is a sad and ugly mess.

Here is an excerpt from a Christian Science Monitor article:

Inside dusty, barricaded camps around
Iraq, groups of American troops in between missions
are gathering around screens to view an unlikely
choice from the US box office: "Fahrenheit 9-11,"
Michael Moore's controversial documentary attacking
the commander-in-chief.

"Everyone's watching it," says a Marine corporal at an
outpost in Ramadi that is mortared by insurgents
daily. "It's shaping a lot of people's image of Bush."

The film's prevalence is one sign of a discernible
countercurrent among US troops in Iraq - those who
blame President Bush for entangling them in what they
see as a misguided war. Conventional wisdom holds that
the troops are staunchly pro-Bush, and many are. But
bitterness over long, dangerous deployments is
producing, at a minimum, pockets of support for
Democratic candidate Sen. John Kerry, in part because
he's seen as likely to withdraw American forces from
Iraq more quickly.

"[For] 9 out of 10 of the people I talk to, it
wouldn't matter who ran against Bush - they'd vote for
them," said a US soldier in the southern city of
Najaf, seeking out a reporter to make his views known.
"People are so fed up with Iraq, and fed up with
Bush."

With only three weeks until an Oct. 11 deadline set
for hundreds of thousands of US troops abroad to mail
in absentee ballots, this segment of the military vote
is important - symbolically, as a reflection on Bush
as a wartime commander, and politically, as absentee
ballots could end up tipping the balance in closely
contested states.

It is difficult to gauge the extent of disaffection
with Bush, which emerged in interviews in June and
July with ground forces in central, northern, and
southern Iraq. No scientific polls exist on the
political leanings of currently deployed troops,
military experts and officials say.

THEME: ELECTION & TERROR PREMIUM
SENTIMENT: CAUTION
The market continues to be cautious. As such, it is still in a bullish mode and has room to rally.

The election outcome is really the thing that the market is watching with baited breath. It is interesting that the dictum that politcos began to accept as truth was "Its the economy, stupid." People are puzzled that this election does not seem to be about the economy, but Iraq. In actuality, both are one and the same. The market is charging a huge terror premium. The War on Terror on the domestic front looks good because we haven't had any major terrorist incidences since 9/11, but the War in Iraq does not look so good and the price of oil is a gauge for that. Until the market can get around the fact that a dirty bomb is less likely to be exploded in a large modern city or that another plane won't be crashed into a skyscraper, it will continue to be cautious.

The market was more than willing to give John Kerry a chance to offer it a better way on both the economy and the war, but his message has been muddled.

Here's what the market knows about George W. Bush:
1. He has cut dividend and capital gains taxes
2. He has cut income taxes
3. He has increased the deficit but interest rates remain low

The market likes these tax measures but it would like a safer world even more. As far as the deficits go, as Dick Cheney supposedly said "Deficits don't matter." Certainly for bonds they haven't, but let's hope the Chinese and Japanese continue to agree.

Unfit for Command continues to fly off the shelves. John Kerry has failed to neutralize the image that it has portrayed.

Here are the two negative images being portrayed:
John Kerry
1. Opposed Vietnam War before going
2. Fought for less than the standard 1 year tour
3. Had purple hearts but was not hospitalized
4. Came home and protested
5. Is photographed with the North Vietnamese

George W. Bush
1. Rich daddy
2. Jumped the list to get into the National Guard
3. Punted on his guard duties

The problem with both negative images is that Bush comes off as a coward who acted like many rich well-connected cowards, while Kerry comes off as much more scheming and duplicitous. The real issue here is which candidate is more predictable? Its easy to understand the psychology of a coward. Its much harder to understand the psychology of someone who fights in a war that he opposes.

America is trying to judge who to depend on to lead us through the mess that admittedly Bush got us into. Behavioral Finance has documented that people are risk averse and would prefer not losing rather than winning. Kerry is the riskier quantity because he has never been President. His "waffling" and his so far unexplained behaviour in Vietnam makes the market nervous because we don't know what to expect from the guy. At least with Howard Dean, he played the same notes consistently.

As the market is coming to see that Bush is the likely winner, it will then focus on the tax benefits of continued Bush leadership. That is why dividend plays are leading the rally!

My prediction is that the rally will continue straight up till Election Day. So stay long and keep watching for changes in sentiment.

I still support John Kerry, but I have learned a long time ago not to fight the market for political reasons. It is better to give money away to charity than to lose it in the market.

THEME: CHINA & INFLATION & HOUSING & IVAN
This is an interesting excerpt from a CNN article:

China is taking about 40 percent of the world's cement production and about a third of its steel, according to the National Association of Home Builders. And, perhaps more important, its demand for cement and other products is affecting the shipping fleet that used to carry materials here.

"The ships that were being used to transport cement here are being diverted to the Orient, to China," NAHB chief executive Jerry Howard said. "It's more attractive financially for them to make a run from Southeast Asia . . . and from Greece [two big cement-exporting nations] to China than to ship to the United States."

America imports about 20 percent of the cement used here, but Florida, the hottest building market in the nation, imports about 40 percent of its supplies. Florida's demand for cement is high because building codes require concrete framing materials to protect against hurricane damage.

Before this year's hurricanes, the NAHB said its survey of builders showed 41 percent of respondents citing cement shortages, a huge jump from May, when 11 percent of those polled reported problems, and from March, when only 3 percent of builders noted difficulties.

The Portland Cement Association, a trade group representing U.S. and Canadian companies, last month said that 29 states were experiencing shortages.

Cement industry experts say the recent hurricanes could ease the cement problem temporarily because Florida builders can't work, at least for a little while. But they anticipate that reconstruction and the resumption of new building will quickly push demand back up.

China is cleary the main driver of the perplexing dual nature of the current economy: inflation & deflation. Inflation comes in when China strives to grow. It creates shortages in commodities. Deflation comes when China undercuts the world in manufacturing. This is one of Soros' virtuous circles. It will take just 10 more years before China will be Japan & the US's biggest strategic competitor.

SENTIMENT: NEUTRAL
Today was an inside day for the market. Sentiment is completely neutral. What this means is that bulls & bears are in a draw. This makes the highs and lows of today very important for determining the future direction of the market. Friday & Monday will be critical. Wait for the volume to confirm any move.

THEME: FED HIGH FIVE?
Here is an interesting clip from an article today:

In their study, Bernanke and his co-authors provide hard evidence that the Fed's ability to steer the economy often depends far more on what it says than on what it does with interest rates. Moreover, they say, the Fed's "considerable-period" maneuvers had an even bigger effect on longer-term interest rates than previous statements of the FOMC.

"Shaping investor expectations through communication does appear to be a viable strategy," Bernanke and his co-authors, Vincent Reinhart and Brian Sack, concluded.

Seems that ole' Ben Bernanke's star is rising in the Fed. He was credited with the dramatic shift in the Fed's policy in 2002-2003 to fight DEFLATION. Now, he is being credited with this new clever strategy of using phrases like "considerable period" to nudge the markets up without actually giving them any real changes in interest rates.

I think the Fed is suffering from a bit of hubris here. It makes me really nervous about 2005.

SENTIMENT: GREED
The market is beginning to figure out the things that I have been talking about. People are starting to get bullish. RSI is starting to top out. I think that tomorrow could be a down day, so I am going to hedge.

MEMES: SOFT PATCH / SEPTEMBER / BUSH VICTORY

These are the three memes driving the market now. Caution remains the predominant sentiment.

"Soft patch" is a phrase that originates from Greenspan's recognition of the slowing economy. Economists are debating the cause and extent of this. By the time they figure it out, the market will have moved.

September is historically the weakest month for the stock market during the year. Having 9/11 fall in September doesn't help matters. Of course after September, there's October with all is associated bad memories.

The Bush Victory Meme is beginning to gain momentum, as more people are causally associating the stock market bounce with Bush's bounce in the polls. The Kerry camp is essentially affirming this bounce by running around trying to neutralize the Swifties accusations. I think the public sees that Kerry is acting kind of guilty by avoiding the issue. If Kerry simply held a press conference with his Band of Brothers standing behind him to deal with the accusations head on, the issue would be dead and buried. Instead, he tried to ignore it. Not smart. I heard about the Swifties in an NPR report at least a month before the convention. There was plenty of time to deal with it.

The debates can turn things around, but Kerry must come up with some headshots if he wants to score points. There are plenty of reasons not to vote for Bush, but there aren't enough reasons to vote for Kerry.

THEME: BULLISH CYCLE
The market continues to act and feel bullish.
Sentiment continues to be sceptical.
Semis bounced hard today based on some upbeat news by Nokia and National Semiconductor. People have been burnt badly by this space. Consensus is that more bad news is still to come. Texas Instruments reversed its previous 5 days losses and rocketed higher. It all acts like people are rushing to cover some shorts. It feels unsustainable. Sentiment refuses to peak, which gives this run more energy.

I will stay long SMH until the sentiment shows some sort of peak. Nasdaq is leading, which hasn't happened in a while.

AAPL continues to make higher highs, although it was pounded by a downgrade from Bear Stearns today. AMZN continues to languish. Apparently, I have yet to see anyone make the connection that the iPod cannot be good for AMZN. I continue to hold the AAPL/AMZN spread.

THEME: PSYCHOLOGY OF BUSH'S SPEECH

Particularly the broad masses of the people can be moved only by the power of speech.
-- Adolf Hitler

There is a very simple tell about the Bush speech: if you click on the official Bush website, you will not see the speech available in video. However, you can see the speech on Foxnews, click here.

Whenever the heart contradicts the mind, there is a trading opportunity. In
psychology, it is called cognitive dissonance.

The media can pretend not to have seen "it" but they cannot ignore it sub-consciously. The "it" am referring to is the same thing that occurred during the famous 7 minutes of Fahrenheit 9/11 that Bush spent reading My Pet Goat when he should have been on his feet fighting a war. On RNC night,"it" occurred when a protestor began interrupting his sentence "Our strategy is succeeding" about halfway through the speech. The crowd started chanting "4 more years" out of synch with his speech, apparently in a pre-programmed effort the drown out the protests. Bush glanced around nervously, and tried to keep on going. But then for a few seconds, his eyes left the teleprompter to survey the crowd and figure out what was going on. He paused and in his eyes, you could see the same mixture of confusion, nervousness, and unmistakably, fear. It is the same fear and hesitancy that we saw during the 7 minutes spent reading a book while knowing full well the USA was under attack.

Was he afraid of assassination? Was he afraid of embarrassment? Was he afraid that the people would see that the Emperor had no clothes on?

You can see "IT" by clicking here to Foxnews and going to the very end of Part 2, the whole thing starts from there and continues to the end.

The entire second half of his speech was pained. He flubbed various lines. The audience's fire was doused. He looked like he wanted to rush through it and get off the stage.

Bush has never been comfortable with making speeches. In fact during the speech, he mocked himself by talking about how Arnie had to "correct my English." However, as with a lie detector test, few human beings are physically able to hide their true psychological disposition.

Specifically, it was interesting to see which lines Bush stuttered, which lines he read with flat intonation or unnatural stress, and which lines he actually nailed and generated a true emotional response. Also, what the news will not report is that the two disruptions by protestors really shook up Bush. Prior to the disruptions, he looked like a gymnast on the balance beam just trying not to fall off. After, the disruption, Bush started flubbing his lines. What I saw in the faces of the delegates was anxiety. Even Giuliani had a pained look (I was watching NBC). Live TV is a bitch.

First, the lines he nailed were:

1. To create more jobs in America, America must be the best place in the world to do business
2. ...so we unleashed that energy with the largest tax relief in a generation.
3. If you say the heart and soul of America is found in Hollywood, I'm afraid you are not the candidate of conservative values.
4. Because the union of a man and woman deserves an honored place in our society, I support the protection of marriage against activist judges.
5. That would be nations like Great Britain, Poland, Italy, Japan, the Netherlands, Denmark, El Salvador, Australia and others - allies that deserve the respect of all Americans, not the scorn of a politician.
6. Some folks look at me and see a certain swagger, which in Texas is called "walking."
7. Now and then I come across as a little too blunt. And for that we can all thank the white-haired lady sitting right up there.
8. ...whatever strengths you have, you're going to need them.
9. I've held the children of the fallen, who were told their dad or mom is a hero, but would rather just have their dad or mom.
10. I've met with parents and wives and husbands who have received a folded flag and said a final goodbye to a soldier they loved.

Interestingly, the lines he flubbed were many more. Specifically, the first 1/2 of the speech was a sort of mini State of the Union, and the delivery was flat and uninspiring. Its hard to be inspired reading someone else's speech on the issues of health care, education, and jobs. I am pretty sure these ideas will be filed behind the Mission to Mars.

However, the lines he had real trouble with were:

1. His taxes - his policies of tax and spend, of expanding government rather than expanding opportunity, are the politics of the past. We are on the path to the future, and we're not turning back.
2. We went to the United Nations Security Council, which passed a unanimous resolution demanding the dictator disarm, or face serious consequences.
3. Free societies in the Middle East will be hopeful societies, which no longer feed resentments and breed violence for export. Free governments in the Middle East will fight terrorists instead of harboring them, and that helps us keep the peace.
4. And then our troops will return home with the honor they have earned.
5. We soldiers of yours are doing great and scoring victories in confronting the evil terrorists.
6. You are involved in a struggle of historic proportion.
7. Today, the government of a free Afghanistan is fighting terror; Pakistan is capturing terrorist leaders
8. Not long ago seven Iraqi men came to see me in the Oval Office. They had X's branded into their foreheads and their right hands had been cut off by Saddam Hussein's secret police, the sadistic punishment for imaginary crimes. During our emotional visit, one of the Iraqi men used his new prosthetic hand to slowly write out in Arabic a prayer for God to bless America.
9. I am proud that our country remains the hope of the oppressed and the greatest force for good on this earth.
10. In every military headquarters, one meets alarmed officials doing their utmost to deal with the consequences of the occupation policy that they admit has failed.
11. ...who with the American people persevered, knowing that a new democracy at the center of Europe would lead to stability and peace.
12. I've tried to comfort Americans who lost the most on Sept. 11, people who showed me a picture or told me a story, so I would know how much was taken from them.

To access the text of the speech click here.

The first half of the speech was flat and uninspiring. The second half was wobbly and unbalanced. But like a gymnast, who totters her way on the balance beam, but sticks her landing, Bush stuck his landing by getting teary-eyed at the right moment: the end. Kudos to Karl Rove for engineering this moment by triggering thoughts of seeing children who've lost their parents.

Now a detractor could easily say that Bush is simply not a good speech maker, but he has other strong points. I don't doubt that Bush is a strong fund raiser and it would seem that he is better in more casual settings.

However, as Hitler understood, speech is the method to move the masses. By analyzing his speech, it is clear to me that Bush feels genuine empathy towards the victims of 9/11, and has a genuine desire to respond to the attack, if only to extract payback. What Bush lacks is confidence in the current policies on the War on Terror. He also does not take the analogies to WWII to heart.

Also, it is clear that Bush feels passionately about taxes, business, gay marriage, abortion, and the role of religion. He does not exude genuineness in any of his domestic agenda, except for perhaps education.

So, in the end, we are left with this feeling that we do not have very good choices. Kerry does not seem to be the obvious answer to Bush's short-comings. But, Bush does not engender enough confidence either. So, the Election is still a coin toss, slightly weighted to Bush. No real change.

However, sub-consciously, who can feel very secure when the RNC cannot even shut out possible double agents from infiltrating their home field? Does Bush really understand why someone would risk spending time in jail in order to get within earshot of him and the nation? Furthermore, does he really understand the energy and hate that is required for someone would throw away their own life to kill Americans? Where does this negative energy come from? And is it growing or receding?

Clearly jingoism gives us no comfort. Perhaps Bush said it best when said about the War of Terror, "I don't think you can win it."

The effect for the market is a slight negative, but we need to monitor events closely.

THEME: ECONOMIC GIRLIE MEN
Following up on my bullish call several days ago, I noticed that people were beginning to hear Arnie's plea to "Don't be economic girlie men!"

The GOP convention is getting Wall St. pumped up. This is helping to fuel a rally that was already technically in the making.

Donald Luskin, who has been pretty bullish and losing money being over-weight in tech, was pumped by Arnie's speech and wrote:

Fact is, just about everything is looking great as far as I can tell. The price of oil has cracked from its bubblicious highs near 50 two weeks ago. And a surge in President Bush's popularity and poll-appeal over the last two weeks suggests that the electoral uncertainty that has been dogging the markets might be near an end.

You can say what you want about America's infatuation with fame and Hollywood, but it works. Yeah, yeah, Karl Rove got this one right. Also, if you've never tried to do Arnie's old body-building routines, you have no idea how hardcore this man is.

Clearly Gray Davis and Cruz Bustamante miscalculated in the 2003 California Governor's recall election. They should've consulted Sylvester Stallone (who would've guessed that Arnie's old nemesis would be struggling to do reality tv). Unless Kerry comes out swinging soon, he's likely to be seen as a girlie man too. Maybe instead of wind-surfing and snowboarding he should go into the gym, put on a couple 45 lb. Olympic plates on the bar and start getting pumped up.

THEME: OCTOBER SURPRISE, update
Loyal readers will know that I have been predicting that the nature of the October Surprise will concern Iran.

Here is something from Reuters that will provide nice cover for W if Israel decides to hit Iran:

In the confidential report, obtained in full by Reuters, the International Atomic Energy Agency (IAEA) said Iran planned a large-scale test of a uranium conversion facility this month.

"Iran's announcements are further strong evidence of the compelling need to take Iran's nuclear program to the Security Council," U.S. Under Secretary of State John Bolton said in a statement. The Security Council can impose economic sanctions.

I know, detractors will say that Israel would prefer Kerry rather than Bush. That may be true, but there have been stranger bedfellows than this. The sight of McCain giving Bush a loving hug is a case in point.