The Rally Continues

I wrote on Sept. 18, “Part of my forecast from the beginning of the year…was for an end of year recovery. It’s looks to me like the recovery has already begun, and I’m putting more money to work immediately.” That was a good move.

Strong earnings and further evidence of a soft landing in the economy sent the market higher this week:

Dow ……………. 11,961 +0.9%
Nasdaq …………. 2,357 +2.5%
Nasdaq 100 ……… 1,727 +2.5%
S&P; 500 ………… 1,366 +1.2%
S&P; Midcap 400 ….. 785 +2.8%
S&P; Smallcap 600 … 389 +3.2%

Optimism returned to the market on Monday, despite news of North Korea’s nuclear weapon test. Google (GOOG) created excitement with a video content deal with Warner Music Group (WMG) and later the much-covered deal to acquire YouTube for $1.65 billion. That lit a fire under technology.

Financials also continued their recent strong performances. The sector looks set to boost S&P; 500 earnings on business fundamentals and with a further helping hand from the end of Fed rate tightening.

Oil prices took a ride, first up on reports that OPEC would cut production, and then down on follow-up reports that OPEC President Daukuru saw no need for an emergency meeting. Our new oil holding slipped 2% for the day. I wrote last weekend that I think OPEC will reduce output if prices fall much, and I still think so.

The Dow gained 0.1% and the Nasdaq gained 0.5%.

Tuesday brought another all-time high on the Dow as oil prices fell anew, this time to the tune of -2.4% to less than $59 per barrel. Yet, rumors of the yet-to-materialize OPEC production cut were enough to float optimism in the oil patch and send our oil services stock up 5.4%.

The Dow rose 0.1% and the Nasdaq 0.2%.

Wednesday extended Tuesday’s oil price shrinkage by another 1.5% to a new low at about $57.50 per barrel. Hope of help from OPEC failed to maintain any cheer from the day before. Instead, fear ruled the energy sector and spread throughout the market as traders worried that reduced earnings from the energy engine might squash large caps as a group. Our recently purchased oil services company fell 2.9%.

As you can see, oil is at an inflection point with traders jockeying for position on either an imminent price breakdown or the building of a base ahead of long-term factors pointing to sustained or higher prices. We made our bet a couple of weeks ago on the latter scenario by buying Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. at $35. It’s been bouncing ever since in a range between a few percent above and below our buy price.

As ever, oil prices bear watching, not only as a part of our portfolio but also as a major factor in whether inflation affects Fed policy on interest rates and the economic soft landing story. We may be able to hit the sweet spot with oil high enough to keep earnings coming strong from the energy sector, but low enough to allow the economy to muscle through a slight slowdown. So far, so good.

The FOMC minutes predicted that the economy would continue to moderate in the second half of this year. We’ve known that for a while. In fact, you and I were discussing that way back in January. The reason it’s still news is that it increases the odds of the Fed keeping rates steady.

Good news to be sure, but it was trumped by recent statements from Fed officials who’ve sounded worried still about inflation. Bond traders haven’t liked the sound of that, so they’ve sold off Treasuries and market interest rates have risen.

Now, rising interest rates from any source are not good for the financial sector because they raise the cost of borrowing. In the wake of that news, Legg Mason (LM) warned that fiscal Q2 earnings won’t meet expectations. Then, a trifecta of bad news for the financial sector was completed when Bank of America (BAC) received a downgrade from Bernstein.

This stew put off enough of an odor to keep the markets slightly down for the day.

The Dow lost 0.1% and the Nasdaq 0.3%.

Do not despair, however. As the theme song of Annie predicts, the sun did indeed come out tomorrow.

Thursday was blessed with an improved earnings outlook and evidence of the economy settling into the soft landing the Fed wants.

Costco (COST) beat expectations and forecasted 15-19% earnings growth in fiscal 2007. That sent its stock up 8%. Then PepsiCo (PEP) reported a more than 70% gain in earnings, giving hope that the S&P; 500 would post a 13th quarter of double-digit profit expansion.

Technology continued its recent outperformance as investors picked up on the improving growth outlook. Windows Vista is looking ever closer. Intel’s new chips are getting rave reviews and are penetrating the market week-by-week. This rising technology scenario is one that The Kelly Letter has been preparing for since the beginning of the year.

Pushing the Dow higher was McDonald’s (MCD), which gained 3% to a multi-year high on news of higher-than-forecasted September same-store sales.

Finally, the Fed’s Beige Book gave a thumbs-up on the economy. Despite a slowing housing market, the report found that manufacturing activity is basically healthy in most districts, wage growth is modest and not pushing prices unduly higher, and that in general there are few signs of upward pricing pressure.

It was enough to send our portfolio soaring: computer security firm +4.9%…oil services company +4.6%…computer maker +3.9%…semiconductor maker +2.9%…software company +2.5%…debt collector +1.8%.

The Dow gained 0.8% and the Nasdaq surged 1.6%.

The market rested a bit on Friday when General Electric (GE) merely matched earnings expectations. That’s not bad, but its not the stuff that parties are made of.

Then the Commerce Dept. revealed that September retail sales fell 0.4% against expectations. Sales excluding autos fell even farther, 0.5% to their lowest level in three years. Word went out that the consumer is dead and the red flags of a not-so-soft landing were being prepared for unfurling when some guy with a calculator mentioned that the drop in sales was mostly due to an eye-popping 9.3% collapse in the price of gasoline, which is good for the economy. The red flags went back in their sleeves, but the crowd remained unenthused.

The Dow gained 0.1% and the Nasdaq 0.5%.

There’s actually not much in the way of news for us. We’re simply seeing the trends we prepared for finally take root. My readers have known the case for investing in technology for the past year. Now, the market is finally getting the memo and we’re reaping the rewards.

Jim Cramer wrote about this trend last Wednesday on RealMoney.com:

I think that both AMD (AMD) and Intel are going to have very, very strong quarters, really strong. I also think that will reflect well on the semi equipment makers (even as I don’t like them) including Novellus (NVLS), KLA-Tencor (KLAC) and the big daddy, Applied Materials.

This a new trend, the money coming out of the Procter & Gambles (PG) of the world, and that money will like big, traditional semis, like the Intels and the Texas Instruments (TXN) (even as I don’t much care for Texan because I don’t think the earnings will be there). That money will also trickle to the down-and-outers like Marvell Tech (MRVL), which I have been buying for Action Alerts PLUS.

I also think that this money will continue to go to the real pros: Cisco (CSCO), Microsoft (MSFT), Oracle (ORCL) and Hewlett-Packard (HPQ). I know it seems that those moves are well played out. They aren’t. There is much more mone
y coming to them.

I agree that there’s much more money ahead, which is why I’m still gunning to get even more exposure to technology than we already have.

Our permanent portfolios don’t get the respect they deserve except when times are good. As you know in your mind but might not feel in your heart, it’s best to buy into them when they’re down. They always come back, and with a vengeance. To wit, Double The Dow was down some 5% in July and now it’s up 20%. Maximum Midcap was down 11% in July and now it’s up 7.5%. The permanents may not be as exciting as our individual positions, but they are the result of years of research on my part and staunch defense at presentations, and they work. They are volatile by design, which is why dollar-cost averaging works so well in them, but they rise substantially over time. They are deceptively simple, requiring almost no work on the investor’s part, and that may be why some find them uninteresting. Their returns, however, are anything but. Do not dismiss these fantastic market strategies, brought to you exclusively by The Kelly Letter.

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