2005 Stock Market

Many technical and fundamental analysts and advisors have become wildly bullish based on the historical performance of the markets in the Fifth Year of the Decade. While I cannot rule out the significance of this phenomenon, I am not one to recommend putting 登ne痴 feet on the edge of the cliff� either.

In Yale Hirsch痴, 鉄tock Trader痴 Almanac� the publication claims that the fifth year of every decade are exceptional years for the stock market as measured by the performance of the S&P 500. While this 5th year track record has the potential exceed even the most optimistic forecasts, I am of the opinion that we must significantly reduced our market exposure during this rally. In a few moments, I will discuss why we will take defensive action as this phenomenon unfolds.

Prior to the last Decennial Pattern ending in 5 (1995), 1994 was a year filled with pessimism and fear. In 1994, short selling as measured by short interest, was at historically high levels, and short covering often provides the catalyst for huge market advances. The current short interest for the Dow Industrials is at lows not scene since 1987. The unraveling of the massive short positions in 1994 lead to a historical rally that drove the market averages up 223% by 1999. These historically high short positions do not exist today. If 2005 were to follow the normal pattern of years ending in �5�, the month of January would register big gains, and then settle down until mid year. I believe we should shift the focus of our portfolios toward defensive groups as the rally unfolds.

Reasons for Our Defensive Posture

1) This is still a Cyclical Bull Market--Basically a cyclical bull market is a rally within a bear market. Many big name blue chips and technology stocks are still way below their 2000 highs. The cyclical bull market that began in May 2003 can closely resemble a real bull market, but usually falls short of making meaningful new highs on the market indexes.

When a cyclical bull market ends, the market usually reverts back to the next leg of the bear market phase. The market averages can reach new cyclical highs before reverting back to a bear market pattern. If the market can reach new highs, sustain those gains, and continue to move higher, a new bull market will have begun. I don稚 think this will happen. The market may have the capability to reach new highs, but may not have enough power to sustain those gains and break higher.

The key numbers we will be focusing on are the S&P 500 at 1250. If the S&P 500 can break above the 1250 mark, it has the potential to reach the 1400-1500 level as investors begin to believe the market is in a new bull phase. If the Dow breaks above the 10,800 level, it is possible for the major average to reach the 11,800 level before running out of steam. The NASDAQ has the potential to reach the 2500-3000 level before exhausting itself.

I will begin getting defensive on the S&P above 1250, 10,800 on the Dow, and 2300 on the NASDAQ. I will gradually sell stocks in cyclical, consumer discretionary and financial sectors on the way up. Since we can rarely get out at the top and in at the bottom, we may have to exercise some patience until the market peaks.

2) The Trade Deficit, Interest Rates, & Inflation--The trade deficit has been a source of irritation and embarrassment to the Bush Administration. Despite the strong dollar talk by Treasury Secretary John Snow, a weak dollar has kept inflation fears in check. The decline of the dollar makes goods overseas more expensive in the U.S, but since countries like China peg their currency (Yuan) to the dollar, as the dollar declines so does the value of the Yuan. As a result, the trade deficit continues to grow. The U.S has been putting pressure on the Chinese to allow their currency to float. China does not feel it is their best interest to do this since their exports will become less attractive in the U.S.

The issue of the trade deficit is beginning to take on a personality of its own. A double edge sword scenario is beginning to unfold that could cut investors and consumers regardless of the outcome. Here are a couple of scenarios:

a) China Floats their Currency--If this happens; the Chinese currency will gain in value making products manufactured overseas more expensive in the U.S. Since many U.S corporations have sent manufacturing and apparel jobs to China, the items produced overseas will cost more in the U.S creating inflationary pressures on our economy. In addition, U.S corporations that have operations in China will see their profit margins decline if prices rise and demand decreases.

On the positive side, the trade deficit will improve, the dollar will rise, and the price consumers are paying for oil will decline. Since oil is priced in dollars, the consumer has been paying a premium due to the dollars decline.

The Federal Reserve has been raising short term interest rates to support the dollars decline. If China floats their currency, the Fed will no longer have to raise rates to support the dollar, but may have to continue raising rates to fight off inflation.

b) China does not Float their Currency--The trade deficit would continue to be a problem, the dollar will continue to be weak, and oil prices will remain high. The Fed will continue to raise interest rates, and try to convince other country痴 to lower theirs to support the dollar.

Whatever the outcome, the solution will not be an easy one. In spite of the Feds attempt to raise interest rates, the only real control they have is over the Discount Rate and the Fed Funds Rate. Both key short term rates have risen 125 basis points (1.25%) over the last 12 months, while the 30 year Treasury Bond has barely budged (5.08 /12-2003, 4.94/ 12-2004). Why is this?

An ongoing battle has been taking place between the U.S and China on several issues. The issue you hear the most about is obviously the trade deficit. The battle you hear about only occasionally is the battle over Taiwan. From time to time you will hear media rumblings about the Chinese/Taiwan debacle. The bottom line is China wants Taiwan under their control, and they want it badly.

China and Japan have been a major buyers and holders of US Treasury bonds, and this demand has kept longer term interest rates low. The Chinese are using their holdings of US debt as a trump card over the heads of the US Government. Should the Chinese begin to sell the massive hoard of US debt that they hold, longer term interest rates would spike, and the US economy would begin to suffer. This is the major reason I am a net seller of speculative real estate holdings, and suggest you significantly reduced your holdings in Real Estate Investment Trusts (REIT).

The bottom line here is something痴 got to give. If history is any indicator, something will eventually give.

3) China is heading for a Hard Landing--A hard landing has its good and bad points. The good side is that oil prices and commodity prices will get some welcomed relief. The bad side is that US corporations that have been benefiting from China痴 prosperity will see profits decline. Obviously, investing in companies whose earnings rely heavily on China for business will take it on the chin. We will try our best to avoid those company痴.

There will be a tremendous opportunity for those of us who take advantage of China痴 hard landing. I will be recommending Chinese exchange traded funds, and company痴 who rely heavily on China for revenue after the correction. Until the correction occurs, stand aside.

Sector Focus & Strategy

As I had mentioned earlier, I will be underweighting positions that may be severely impacted by a downturn in the economy. Specifically, I will be underweighting Consumer Discretionary (Retail, Homebuilding, Home Improvement, Leisure, Appliances, Hotels & Restaurants, and Auto manufacturers), Financials (Banks, Brokers, and Insurance), Technology (with the exception of select software companies), Utilities, and Industrials (except for Aerospace & Defense, and Railroads).

We will overweight the Telecommunications Sector (Integrated Telecom Services), Healthcare (Pharmaceuticals, Managed Health Care, Health Care Facilities, Equipment, and Biotech), Consumer Staples (Soft Drinks, Food Chains, Packaged Food).

Lastly, I will continue with a neutral weighting on the Materials and Energy Sectors with every intention of adding to positions on weakness.

What to Do Now:

Continue to check John痴 Journal daily for any changes to our positions in the Big Picture Portfolio. I will not bore you with meaningless updates unless circumstances warrant, but do check in daily for possible changes.This month痴 option expiration is on Friday, January 22nd. We currently have two call positions (Best Buy, January 55 call, and the IBM January 95 call) that will expire on that date.

I recommend that you continue to hold our 5% weighting in the Rydex Tempest 500 Fund (RYTPX) as a market hedge. I do anticipate raising the weighting in this position to at least 10% or more in the weeks to come. Also continue to hold the Pro Funds Rising Rate Opportunity Fund (RRPIX).

For those of you looking for places to invest for income, be patient and keep your money in a money market account and 1-3 month cd痴. Remember, your money market account has given you a nice raise this year with no risk to principal.