Zowie, the Dow Jones Industrial Averages (INDU) have hit 14,000 - couldn’t hold it yet but did hit it. Still a bull market? For that to be, the INDU must break through 14,000 and leave it behind. But where is the energy for such a move?

First concern: since the INDU’s March 2007 bottom, it’s up roughly 2,000 points without a real correction, unless you count the 400+ point drop in June. We could be seeing the beginning of the real correction, which would be very healthy for letting the bull run some more. Or the bull could be nearing the end of the run. I’m not a perennial bear like many are, but anyone knows a bear market when we’re in one. The trick is to see it coming in advance and construct trades in a way that does not cause real damage if the bear takes over.

Housing
Home prices peaked in October 2005, inventories are growing, housing starts are slowing and subprime defaults are accelerating. Over 30 subprime lenders have gone under. Even the Alt-A mortgage segment (better than subprime but not prime) is coming under pressure. Seriously tightened mortgage lending standards are slowing the housing juggernaut, which will depress housing further. This is very troubling: nearly 3/4 of the growth in GDP - the economy - over the last few years came from mortgage equity withdrawals (MEW - home equity loans), not from tax cuts, and the MEW game is severely curtailed. Without MEW to power consumer spending and corporate spending not taking up the slack, where will GDP growth come from that fuels the stock market?

This wasn’t a housing bubble, it was a credit bubble, and the credit has been largely choked off. Two of Bear Stearns’ hedge fund groups are worthless due to ruinous speculation in subprime lending. We are not even close to the bottom of this subprime mess. And housing has not hit bottom, not by a long shot; that won’t happen even in 2007.

Corporate Earnings
Earnings have hit record highs in recent years, and earnings growth in the last few years has been the strongest in over 50 years. We’ve had five years of stellar earnings performance, which has been responsible in large measure for the bull market and its new highs. Impressive. They seem to be starting to fall, though, though some analysts see a rosier picture. Right now, we see Google, Motorola, Pfizer, Caterpillar and others either reporting losses or guiding lower for the future. Business runs in cycles, it can’t always be higher earnings every quarter.

I’m not seeing how the end of the housing bubble and falling - or even stagnant - corporate earnings make the case for continuation of a bull market. What engine will power it onward? This Powerpoint presentation on Prudent Bear concerning the economic fundamentals and what it portends for the market is fascinating… I highly suggest you peruse it.

Covered call writers are highly encouraged to stop thinking in terms of every stock going up and to begin thinking in terms of protecting trades. A market sell-off could be the beginning of a new bear (as was the market top in January 2000) or could be a correction. How will we know? The answer is, we won’t know until the market blows all the way through the traditional retracement levels. By that time, unprotected covered call trades will be hurting us seriously, or we will have stopped out of them at losses.

Conservative covered writers should be prepared to protect themselves.

I make some timely suggestions in my latest MONEY newsLETTER article about using long puts to protect covered call trades - too much detail to go into here. Please check it out. You can subscribe to my free newsletter (just need first name and email) at CallWriter and you’ll get that newsletter issue in moments.

This entry was posted on Friday, July 20th, 2007 at 8:51 pm and is filed under Blogroll, Markets/Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.