This week’s sell off in the markets is very similar to the Q2 reporting season beginning at the end of June or the Q1 reporting period beginning in March to April. Investors are now “Buying the Rumor of solid corporate earnings, and Selling the News, no matter how good it is.

This is one of the oldest and most solid rubricks of the stock market. (Why does it work? I think it is because of human psychology: rumors always originate at a time of fear and weakness in a company stock price; the news of higher earnings a period of time later will be met with satisfaction and smugness, which creates the circumstance for a price peak). Take a look at the charts in late July and early August. This is essentially a repeat performance. But this time, the market is 10% higher.

I think we will see a repeat performance of August and September in November and December. Once the selling has run its course, the market will kick back up for another 10% run higher to 1200 SP500. That is my thesis.

The dollar trade is also exacerbating this pattern. The currency traders, who are by defition speculators since there is no fundamental value behind the trade, have discovered the currency side of this equity-driven pattern. The currency trade is reinforced by the pattern of declining stock market leading to a strong dollar. This has not always been the case, but is now with all markets trading together and the US Dollar as the safety trade (non-risk asset). So, when the markets decline, they rotate to the dollar. This pushes up the dollar and gives the currency traders a big payday by betting against the stock market and for the USD. Here is the chart of the Euro – US Dollar cross. Note the wild swings and their relationship to the US stock market.

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So, the currency traders are adding volatility to the stock market, pushing normal buying and selling up and creating bigger market swings. This should go on for quite a while. But the fundamentals will win out, and there is nothing to indicate that the economic and business fundamentals are not getting better day by day. And the US Dollar must weaken over time against other currencies unless the Fed does something completely unpredicted (and against Bernanke’s past form) and raises interest rates and sops up liquidity way sooner than expected or warranted.

I am staying long this market and finding funds to reinvest at lower levels, by closing out of short positions (mostly covered calls). I expect the market to begin recovering on or about November 10. This is exactly the date when the July selloff bottomed out at 875. That was a time of great fear, but also a time to get long with a 25% up move from there to October 23. Now, Carter Wirth just came on CNBC’s Fast Money and predicted a bottom in this decline of 980 based on his chart work. That is just about right to fit the trading pattern established. From that point, the market can go to 1200 by year end and fit the current pattern. 1200 is also the point at which the market broke down in September 2008. That is a very significant level. After the market makes its year end top, I am in the “sideways” camp with most of 2010 moving up and down in the channel between 1000 and 1200 as the economy recovers and higher earnings eventually push stock prices out of the channel.

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Great Earnings this morning (Tuesday, October 20) from CAT, UTX, PFE and KO. CAT guidance was the economy is improving much faster than expected and the risk of a double dip recession is now ”very low” in 2010. CAT (a proxy for the export driven, industrial equipment market) beat earnings estimates by 85% and had higher revenues than forecast (which is supposedly what the market is begging for). So, what happened to its stock price? Sold off.

This earnings season has become the typical denial event by the Bears. The hardcore bear traders try and sell down every rally and discount any good news as either lies or misinterpretation. They first criticize the weakness of economic growth and unemployment levels, and then turn around and criticize the Fed for using accomodative policy to ramp back up the economy.  (Earth to Bears: you can’t have it both ways, unless Armageddon is your objective, in which case, tight policy will deliver the economic disaster you are awaiting)

This market is still climbing a huge “wall of worry” and so it will continue climbing higher (until all the Bears throw in the towel). When I stop seeing Michael Pento, David Rosenberg , Peter Schiff, Joe Battapaglia, etc on CNBC blasting the Fed and the market, that is when I will Sell.  There is no Euphoria.  There are no “rose-colored glasses.  There are only Bears (likely still short since SP500 of 666) begging for their wishes to be fulfilled.  Please keep ripping the market and economy.  It is making me wealthy.

Today, I was able to roll my October FLRs that were exercised on Friday to November sold puts, and picked up another 0.50 per contract in the process. I also flipped my BHP for a 2.47 gain the past 12 days (closed my Nov 70 puts at 1.75 and opened same number of Nov 75 puts at 4.50 a few minutes later) during the morning sell off. I am now waiting to get back into EWZ as Brazil sold off big today (down to 70 from 76). I will wait for $67 to get back in with some DITM calls on Mar 2010.

I also doubled down on my GE Mar 2010 Calls ($10s) at $5.80. They had been almost $7 a few days ago. Now I have 10 contracts (1000 shares) plus another 500 shares of GE.

Successful investing is all about a contrarian perspective. It is my personal challenge to stay contrary at all times. I am naturally that way, so it is somewhat easy for me. Still, there are times, like June or October 2007, when my contrary warning bells were going off, but I did not listen and I stayed long, much too long.

But just as too much positive talk should trigger a contrary response leading to the action of “Sell”, so too the same is true when there is too much negative sentiment, like right now. I actually allowed myself to be talked into this negativity in late July, much to my personal detriment. I went short the market in some of my accounts, and sold stock and funds in others, with the market at SP500 = 950. I was worried about all the things I should have ignored: approach of 1000 on the SP index, approach of traditional scary September-October time period, talk of a double dip recession, talk of healthcare and all that it would do to the economy, etc.

But now, I have my head back on straight and I am long the markets and am rejoicing in negative talk. For example, today the Chicago Purchasing Managers Index (PMI) report was released. It fell to 46.1 from 50.0 the previous month. It was expected to be at 52.0. Anything below 50 indicates negative purchasing sentiment.

At the same time, the ADP private payroll forecast was weaker than had been expected by market participants and so the stock markets sold off. On the surface, this is bad news and reinforces the “double dip” recession, or “w” stock market talk. It should be a very bearish signal, right?

No. Wrong. In the economy and markets, quite often, what’s down is up and what is up is down. It is a bit of “Alice In Wonderland”. The reason that bad PMI and unemployment data are good? It is that it gives the Fed and Treasury the cover to continue with aggressive monetary and interest rate policy to get the economy back on track. As soon as the economic data turns stronger than Fed forecast will be the day the markets turn down.  The Fed and Treasury will start applying the brakes by raising interest rates and tightening money supply.

Stronger economic data means higher interest rates. Higher interest rates mean an eventually weaker equity environment for no other reason than alternate investments yielding interest rate returns begin to look more attractive and shift some demand away from stock equities.

The sweet spot in any market recovery is when the economy bottoms but before it heats up enough to force higher interest rates to counter inflation. We are right now at the point of optimal return and have been since March. I am staying long until the Fed starts raising rates, probably not till after the middle of 2010.

Here is a video clip on the ADP report:

I am making a bullish call and am selling UNG puts (Oct $18 – UNEVR) for $6.5 this Friday morning (September 18, 2009). While I don’t like UNG longer term because I am concerned about the premium in the stock price (4.58% over NAV today, but was almost 20% at end of August) coming out with a ruling from the CFTC, still it is for now the only pure play on nat gas prices. And I see those prices recovering to at least $5 just on the idea of an economic recovery and even before the inventory runs down.

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Another Nat Gas play is PennWest (PWE), a major Canadian energy producer based in Calgary with more than 50% of its production in gas. I have owned PWE since 2002, in the form of Petrofund before that company’s acquisition by PWE. Today I sold the December puts in PWE $15 for $1.60 (PWEXC). This gives me some upside from today’s $14.40 price and downside protection to $13.40, which has been the recent base level for PWE. PWE was above $30 for two years up until July 2008 and has been over $40 in the past six years. A return to the $30 level will occur with a firming of Nat Gas prices above $8 / mmcf.

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I also am buying more UYG calls. I see UYG at $10 by the end of the year and it is now just above $6. There is a lot of room for improvement in the banking sector, even though it has come a long way already. The sector was down 85% (XLF went from $38 in 2007 to $6) in March. UYG was above $20 just prior to the Lehman collapse. It has retraced much less than half of that. I think another 30% to the upside is very likely before the “V” is completed, bringing us back to August 2008 levels. A 30% move in XLF will be a 60% move in UYG.

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