Dear Diary,

Last week’s Market Commentary to members concluded:

"Technical analysts will cite bullish breakouts and push retail traders into bullish trades now.  We spoke in recent weeks of the potential for the stock market to remain bullish through early May, which would lull investors into complacency, believing that "Sell in May and Stay Away" would not materialize.  Everything is going according to plan in that regard.  The markets remained bullish through last week and optimism is high again that 13,500 will be just around the corner…..we are highly skeptical of any meaningfull bullish follow-through.  By week’s end we will be very surprised if the strength has been maintained and, as a result, are entering bearish positions"

As it turned out, the Dow Jones Industrial Average ended 3 of last week’s 5 trading days lower and ended the week substantially lower. 

On April 14th we wrote in our Monday blog that we expected "strength over the next couple of weeks in the markets assuming the 1325 level can hold…we’re looking for anything above that key threshold level to signal high likelihood of a bullish follow through to the end of the month."

As expected, the bullish follow through materialized once the critical 1,325 level held firm.

One of the factors we consider heavily when trading is general sentiment in the market.  In early May, optimism was high.  The Volatility Index, for example, had not been quite as low since the December and October peaks in the market.  Had all the pessimism of recent months really been eroded?  Had we forgotten so quickly the problems of the past?  We didn’t think so. 

While many were optimistic about the Dow crossing 13,000, we exercised extreme caution and refused to abandon discipline, preferring to stay safe than risk a big correction.  And the correction from approximately 13,100 to 12,745 soon followed. 

Although the correction so far has been just under 3%, it is still almost 3% in 1 week!  If all you could do was improve your portfolio performance by 3% at the end of the year, the effect on compounded gains would be substantial over time. 

For example, $100,000 compounded at 10% over 20 years amounts to just over $670,000 (assuming a qualifed account) while $100,000 compounded at 13% over 20 years amounts to over $1,150,000, almost twice the amount! 

When making big money in the market, the devil is in the details and saving 3% here and there makes a huge difference at the end of a year when comparing actual and potential portfolio gains.

Moreover, when the stock market rises or falls 2-3%, traders seeking greater returns often experience greater account value declines as their individual stocks suffer even more.  So, by-passing a 2-3% stock market decline can mean avoiding a 5%,6% or higher account value decline!  In short, when optimism reaches extreme levels, it’s very dangerous to follow the crowd because the crowd is often wrong at the tops and the bottoms!

Rather than discovering by trial and error with one’s own capital how to master sentiment extremes, it’s often much easier to look back in history.  For example, famed value investor Benjamin Graham suffered at the hands of sentiment when he and his partner Jerry Newman ran a joint account in 1929.

With capital of $2.9M on which $4.5M of outright long positions were balanced and an additional $2.5M of long positions were offset by $2.5M of short positions, the duo believed the matched set of long and short positions presented negligible risk.

At the time, the heavily margined long positions were used to purchase convertible preferred stock or convertible bonds while the common stock was shorted.  As the 1929 crash took full force, the duo reverted to valuation models and believed too soon that it was appropriate to cover short sales yet still hold preferred stock positions.

Graham recalled that his reasoning was "the prices seemed too low".  At the bottom of the market in 1932, the $2.5M capital account was reduced by 70%. 

What were Benjamin’s Graham’s sins?  He had failed to adequately account for the power of sentiment and he had used excessive leverage.

For most of us, it is so easy to feel an opportunity is being missed when a stock is up day after day.  Yet waiting for the pullback and refusing to buy into extreme optimism often serves us much better! 

Next time, you are about to pull the trigger on purchasing stock AFTER a big uptrend, re-evaluate whether it is purely greed driving you to buy.  And next time, you want to panic AFTER a big downtrend, re-evaluate whether it is fear driving you to sell. 

In early April, fear was paramount in the markets, but we refused to give in to it and made some very attractive gains on the uptrend.  In early May, optimism was high, but we refused to buy into the uptrend and kept our powder dry.  We hope you too have navigated this choppy year successfully!

Optionsage @ StockandOptionTrades

Interesting report from Factset titled: "An Oil Bubble to Rival the Internet Boom."

It’s got lots of stats and charts, very nice and the author concludes: "Technically speaking, the energy sector could outperform further in the months ahead, but the correction could be brutal, as is the case with cyclicals. We recommend neutrality on the sector, and sales in line with bad news on the economy."  These are guys who provide top-level reports for hedge funds but it came out last weekend and it seems everyone ignored it…

I was saying in comments on Friday that the price of oil is much like the Terminator robot in the first movie - no matter what bearish fundamentals turn up to stop it, it just keeps coming and coming and it grinds and crawls and claws ever higher…  Here’s the clip.

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I was looking at copper (because of my BHP puts) last week and it went down hard on Friday, touching 370 again and it looks primed for a nice fall.  Far be it for me to bring up fundamentals but there was a 10% increase in stockpiles this month, the most since Aug 2005.  Apparently the Chinese have reached their limit as to what they will pay and have just stopped ordering and a strike that was supporting prices at record levels in Chile just ended (from 4/16).  Here’s an interesting comparison of Copper, Gold and Oil.  Note oil has decoupled from everything - If oil is trading up on international tensions, why not gold?

Again, my premise is that Food, Metals and Oil are currently using ALL of the spare money in the world and for any of them to go up, other things must come down or WAGE inflation must start to really kick in to help us pay for this stuff.  China’s PPI jumped 8.1% and their currency is UP 10% over the past year, which should have kept it down a bit.  They release CPI on May 12th, possibly close to the record 8.7% increase.  “The falling U.S. dollar exchange rate and interest rates and excessive global liquidity’‘ require China to take extra steps to safeguard financial stability, Vice Premier Wang said. “If we don’t handle financial risks well, this could cause turbulence in the overall economy and undermine social and political stability.”  The PBOC’s lending rate is currently 7.47% yet their economy grows at 10.4% and the government runs a surplus.  Is our country run by idiots or what?

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Now, to get off the doom and gloom wagon, Forbes (Capitalist Tools, I think is their motto) says the economy is in better shape than we think and that companies are starting to spend again, something tech needs to make a big score this year.  Forbes is blaming macro funds for being too bearish on the current market troubles.  I’m sorry but I’m still staying 70% cash!  I do think the economy is in good shape but you could be in fantastic shape and a bullet will still kill you - $120 oil is that bullet!

If you’re shopping for a house, think castle!  And, if you’re just shopping - think Baghdad’s fabulous Green Zone district where the Pentagon has a $5Bn plan to build a shopping center with luxury hotels around a brand new $700M US Embassy "whose total price tag will reach about $1 billion after all the workers and offices are relocated over the next year." “When you have $1 billion hanging out there and 1,000 employees lying around, you kind of want to know who your neighbors are. You want to influence what happens in your neighborhood over time,” said Navy Capt. Thomas Karnowski, who led the team that created the development plan.  This is one of those times I really wish I were joking!

"For the moment, however, it’s mortars and rockets — not investment money — pouring into the Green Zone, which includes the U.S. and British embassies, key Iraqi government offices and other international compounds. Militants have escalated their shelling of the enclave since Iraqi forces began a crackdown on Shiite militias in late March."

Yet another economic accomplishment of the Bush Administration - Welfare rolls are on the rise in 27 states, reversing decades of progress!  Bush has cut the welfare budget considerably with just $37Bn in food stamps (a whopping $1,870 per person for the 20M people living in abject poverty).  This is just over the amount of the welfare check handed to JPM/BSC last month to keep those poor people in Cristal and there is a $300Bn welfare bill caled the farm bill moving through Congress that will pay farmers record money at the same time they are charging record money for their food - nice way to buy an election…

Who needs tasers?  Certainly not the Philly police, who get caught beating the hell out of a guy the old fashioned way…

Speaking of guys who need to be tasered - Ron Paul may be out but he’s not down and his supporters are wrecking havok at the Republican primaries (yes, they are still having them).

Someone else who needs to be tasered:  5 ways Hillary can still win the election video.  Slate magazine has a Hillary deathwatch, now down to 2.5% chance of winning while Bush is stacking the FEC to make sure no one gives McCain any troubles.