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Market Update And Forecast

Below is a commentary originally published by www.themarkettraders.com on 31st May 2005:

Stock Market Direction

The saying "sell in May and go away" clearly did not apply to this year. With one trading day left the stock market has enjoyed the best month so far in 2005. There are many indications that this intermediate-term rally is far from over. Short-term, however, there are signs that the market is tired and a quick pull back may start as early as Tuesday or Wednesday. Volume on both NYSE and NASDAQ has dropped off considerably over the last few day, and although it could be attributed to pre-holiday trading, it is never a good sign to see a low volume advance, Holiday or not. Equity only Put/Call ratios, and specifically its 10-day moving average is approaching levels associated with short-term tops. The number of stocks making new 52-week highs is lower compared to the beginning of the rally. Momentum indicators on NASDAQ are getting to extreme overbought territory. As I have mentioned many times in the past, overbought conditions and minor divergences do not mean that the market will reverse. More often than not they produce pull backs and consolidation type action, but we need to see more than just a short-term extremes to reverse this market back to the down trend.

S&P 500 is challenging 1200 area. I view 1200 - 1207 as a minor resistance zone, which should invite profit taking and might send the market down to the first support of 1185 or the second support of the gap area of 1175 - 1179.

S&P 500 Daily:

If the pull back occurs on low volume and there is no impulse to the downside, it might set up a buy signal for short-term traders.

Our clients have increased allocation to US equities with the emphasis on NASDAQ issues on April 20th when NASDAQ closed at 1913. NASDAQ is up 8.5% since then. Short-term traders have also enjoyed several traders on the long side, all resulted in profits. Short-term traders are long IWM (RUSSELL 2000 ETF) from 121.35 (current price is 122.95). Our stop is set at 117. Our profit objective is 124.50.

Today's Focus

Gold Stocks

I have not been interested in Gold stocks for several months. Our clients were advised to reduce allocation to Gold stocks last December when US Dollar approached 80. The inverse relationship of US Dollar and Gold has been with us for many years. Although I am not sure that this is a permanent thing, I have to respect it. And when everyone has given up on the buck 6 months ago and started predicting gloomy outcomes for the US economy, it was natural to do the opposite: sell Gold and buy US Dollar. XAU (Gold and Silver Index) has declined nearly 30% since then. Although I am not wildly negative of the US Dollar, I view Gold stocks as an undervalued asset at this point. Here are my reasons:

Gold Stocks are naturally correlated to the yellow metal. The relationship between XAU and Gold futures has remained stable for many years. The chart below indicates a considerable underperformance of Gold stocks to the underlying commodity. It simply means that stocks are undervalued to what they are dependent upon.

Chart1: XAU divided by Gold Futures. Chart 2: XAU

Note that the area below 0.2 (20000 on the upper chart) has always associated with bottoming process on the lower chart. In other words when XAU is trading at 0.2 or lower in relations to Gold futures, investors should start scaling in to Gold stocks.

Put/Call ratios on XAU have reached some extreme levels a week ago. This is bullish from a contrarian standpoint. There was a lot of fear shown by "wrong way" small traders on both gold stocks and futures. It immediately created a rebound last week. I expect this rebound to be retraced over the coming days, which will create an ideal entry point.

This is not a recommendation for short-term traders. I may have a short-term trade later on. This is what we are going to do for our clients in terms of their asset allocation. The difference is I always specify the exact stop levels, entry points, exit points and hedges for a short-term trade. My long-term clients know that portfolio rebalancing takes a day or two and I do it only when I try to look months into the future rather than days.

Long-term and Intermediate-term investors should increase allocation to Gold Stocks and/or indexes at the close of Tuesday's session.

For your free portfolio evaluation, consultation on trading, alternative investments or trading psychology please feel free to contact me directly at dennis@themarkettraders.com or come visit us at www.themarkettradraders.com.

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