The Wall Street Journal ran a great article on Monday titled “How Skepticism Can Fuel a Rise: A Rally Too Good to Believe Also Has Cash Waiting to Enter; Acute Optimism Is What to Fear” (subscription required):
‘It is taking a very long time for people to believe in the rally,’ says Phil Roth, chief technical market analyst at New York brokerage firm Miller Tabak. ‘It is just hanging on and hanging on.’
I know that’s true because for most of the 19 week rally that has carried the S&P 500 from 1234.5 at the close on Monday July 17 to 1406 at yesterday’s close (Wed Nov 22) I was one of those skeptics waiting for it to end. With the housing market set to take the wind out of consumer spending I knew that stocks would have to feel it.
At first I explained it simply as the market’s belief in a “soft landing”. Warren Buffet once said something like: “A herd of lemmings looks like a pack of rabid individualists compared to Wall Street with a concept.” That concept was the “soft landing” from the housing fall out and it seemed to me like that’s what was fueling the stock market rally.
But a bunch of weeks ago I finally realized that there are fundamental reasons to own S&P 500 companies now as well. The companies in the S&P 500 are the biggest, strongest and best companies in the world. These are companies like Proctor & Gamble, AT&T and Chevron. These are companies that all of us buy products from everyday. Not only that but these companies have strong balance sheets able to weather tough times. In other words, these companies, the biggest and the best, are best positioned to weather an economic slowdown. So a rotation from small to big makes sense. Not only that but small has outperformed big for years now making big much cheaper than small.
And then a couple of weeks ago the last piece of the puzzle hit me. People will continue to believe in a “soft landing” until presented with evidence to the contrary impossible to ignore, the S&P 500 companies are best positioned to weather an economic slowdown and are relatively cheap from years of underperformance and NOBODY BELIEVES THIS RALLY WILL CONTINUE!
That last insight was an epiphany for me. I realized: “Oh my God: going long the S&P 500 for the rest of the year is a trade for which the stars are lining up”.
Why is it bullish that nobody believes in the rally? The WSJ article says it well:
Stock rallies often happen when the market is full of doubters. Those are times when money managers and individuals alike have pulled money out of stocks and are holding cash, bonds or other investments. If the market begins to turn up, these people start to feel left behind. They have money available to shift to stocks, and they do so.
As long as doubters remain to be converted, money can keep moving away from other investments and into stocks, pushing prices higher.
Once the great majority is bullish, however, things are different. Froth appears, as it did during the 1990s. Instead of holding money on the sidelines, people borrow against their homes or from their brokers in order to invest. That is when stocks can be at risk because there is little free money left on the sidelines to move into stocks.
In yesterday’s WSJ “Ahead of the Tape” columnist Justin Lahart made an interesting point. Hedge funds, increasingly important players in today’s stock market, have been defensive recently and are trailing the Dow and S&P 500. Because their compensation is often based on performance relative to these benchmarks many of them will be tempted to play catch up.
I think the stars of lining up for this one. I think there’s a good chance that we’ll see alot of people capitulating and getting into the market in the last 5 weeks of the year.
My recommended way of playing this is to buy call options on the S&P 500 ETF (SPY): Buy the Jan07 $137 SPY calls (SFBAG) for $5.20.
Your breakeven point here is for the S&P 500 to reach 1422 by Friday January 20 – 8 weeks from now. That means you only need the S&P to go up 16 points, a little more than 1%. I’m looking for the S&P to hit 1470, a little less than a 5% gain, by the end of 2006. Were it to do so, these calls would be worth in excess of $10 for a doubling of your money.