Friday, February 17, 2006

Dow Jones 11000 -- Good Bye, or See You Later?

The markets turned in a very good week spurred by the rather upbeat report new Fed Chairman Ben Bernanke gave congress about the strength of the US Economy. The Dow closed the week at 11,115.32, the highest close since mid-2001. I have had a number of people ask if I think the market will just keep going or if it will continue to oscillate around 11000 for awhile. As I said in the previous edition, 11,000 has, indeed, been a psychological barrier, thus The DJ 30's break to a new multi-year high is very good news. In addition, I still believe the Dow Jones is significantly undervalued; thus, there is plenty of room for the market to move higher. Having said this, 11,000 has not been pierced in the way that psychological barriers are normally taken out. I said last time, the DJ 30 has been at or near 11,000 8 times in the last 5 years and has turned back every time. One of the reasons the market turned back each time is the influence of what are known as the "shorts." A short trade is when you sell a stock or index that you do not yet own (Shorts borrow the securities they sell from their brokers) with the hopes that the price will fall and you can buy it back later at a lower price and make a profit. Thus in the seven previous times the DJ 30 reached 11,000, if you had shorted it, you would have made handsome profits because each time the market subsequently fell back to lower prices. You could have then covered your short, by buying the same number of shares that you shorted and collected the difference as a capital gain. Big money, and I do mean big money has been made by the shorts over the last few years. The shorts are big, sophisticated investors, and they do not scare easily. Without a shadow of a doubt they began shorting recently just under 11,000, and I believe they are probably still shorting today. While the shorts do not scare easily, they are completely short-term traders and they will not take losses indefinitely. The shorts will cover by buying the market when they are convinced that stocks are going a lot higher. When they start to cover, they must buy the market, and they operate in a kind of herd mentality. That means when the shorts start to cover you will know it because it will be accompanied by very high volume and sharp spikes in prices, as many of them head for the exits. So far the move above 11,000 has been rather orderly. For me to wave good bye to 11,000, I would like to see a week to 10 days of sharply higher prices. Busting out of a 5 year high ought to be worth 500 points in short covering. This does not mean that this is the only way we can sing our dirge for 11,000, but it is the way that these kinds of psychological barriers normally are laid to rest. I feel confident that 11,000 will be decisively pierced in 2006, but I think it will be accompanied by a lot more noise than we have today. I am bullish on the markets, but I would be surprised if we did not wobble around 11,000 for a while longer.