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.