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Jeff Saut Presents: The Dow 11,000 'Prisoner's Dilemma'


How will the 11000 "Prisoners' Dilemma" be resolved?

Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"Two prisoners are accused of a crime. The prosecutor tells them that if they both confess
they will go to jail for ten years; if neither confess they will get two years; if only one confesses he (the confessor) will get just one year while his fellow prisoner goes down for 20. If they can come to a binding agreement, the prisoners will both profess their innocence and be sentenced to two years. But suppose they cannot. Each prisoner will then see that – regardless of what the other does – he will do better off if he confesses. Both of them confess and get ten years."

. . . The Economist

The Economist magazine used this example of the "Prisoners' Dilemma" to illustrate the manner in which individuals behave strategically in a bargaining situation. It is an example of how "in most bargaining circumstances a deal can be struck that will satisfy all sides. But if there is no agreed way to settle on it, everybody may end up unhappy."

Currently, Dow 11000 appears to have become a kind of "Prisoners' Dilemma." Indeed, on
November 23, 2005 the DJIA finally managed to cross above 10900 in an attempt to challenge the 11000 level. In the 49 trading sessions since then, we can count 29 thrusts above 10900 (including three actual closes above 11000), and as of yet, all to no avail. Unsurprisingly, the "Bulls" view 11000 as a kind of milestone that once surmounted will lead on to fortune and glory. However, they also worry that like the March 2005 attack on 11000, this attempt will also fail causing them to lose the profits they currently have. Should they sell "a little," assuming an upside failure at 11000, or should they "hang on," believing in Dow Delight above 11000?

At the same time, the short-sellers view Dow 11000 as a milestone. Their reasoning is that there is the potential for a round-number upside-failure followed by a 9% downside "hit" for stocks, and maybe more, just like what occurred from the March 2005 upside-failure at Dow 11000. However, short-sellers also worry about the above 11000 "ruin factor" and consequently wonder if they shouldn't "bank" some of their profits just in case last week's Dow Downer was only the pause that refreshes.

How will the 11000 "Prisoners' Dilemma" be resolved? Well, if the Bulls and Bears both behave strategically, the Bulls will do a little "just in case" selling and the Bears will do some "just in case" buying to cover some shorts, since both sides would be prudently, and emotionally, better off by reducing their financial risk exposure. However, since there are many more "longs" than "shorts" the Dow's direction should have a downward bias. And that, ladies and gentlemen, would be consistent with past January Jumps.

Indeed (as stated in last week's verbal strategy comments), after reviewing our stock market notes of some 40 years, January Jumps tend to end during the second, or third, week of January with a sharp/quick downside reaction. That pullback is typically followed by another rally attempt that either fails to make a new monthly high (read: double-top), or makes a slightly higher high. From there, the only question in the short term becomes whether you lose money quickly or slowly. Moreover, the odds that this sequence plays rise dramatically if the December low has been taken out to the downside in that mid/late-January swoon. Unfortunately, this January's sharp/quick pullback from Dow 11048 (1/11/06) to its downside crescendo of 10684 (1/20/06) "took out" the December low of 10709.42 and unfortunately reinforces the topping sequence laid-out in these reports over the past few months.

Recall that for the past few months we have suggested that the S&P 500's (SPX) 1280 – 1300 level would likely be a topping zone and that the top should occur in late January. Given the recent stock market action that strategy is gaining credibility. For example, last week the NASDAQ 100 (NDX) broke below its January reaction lows (1670) and now resides below its
10/30/50-day moving averages (DMA). The NDX's December low is 1641, which is currently its short-term price objective. Failing that level would suggest a full re-test of its 200-DMA at 1591. Of course, there is still the chance that the NDX's breakdown will prove to be a downside non-confirmation since the DJIA (10793.62) and S&P 500 have failed to confirm the NDX by traveling below their respective January reaction lows. Yet, with the MACD, various put/call ratios, sentiment indicators, etc. flashing sell-signals, we remain cautious in both the trading and investing accounts. Additionally, the Internet Index (HHH) is off more than 15% since its January 6, 2006 high, IBM (IBM) is back below $80, and General Electric (GE) is down 10% from its mid-December high, causing one old Wall Street Wag to comment, "If the stock market is a discounting mechanism, what are these bellwethers telegraphing?!"

Obviously, "we are talking our book," which suggests that the Fed will continue to raise interest rates until there is a financial accident in keeping with its historic modus operandi. As our economist Dr. Scott Brown noted about Friday's employment numbers, "Taken at face value the drop to 4.7%, along with the pickup in wage growth, is a serious concern for the Fed." Further, the good folks at ISI have uncovered a report written by Dr. Bernanke back in 2004 suggesting that the Fed should risk a funds rate too high rather than too low. Regrettably, we do not think the equity markets have discounted a 5% Fed Funds interest rate and the concurrent inversion of the yield curve. As the astute GaveKal organization opines, "The upshot could be a pretty ugly situation for all cyclical assets, with statistics unexpectedly weakening, (and) corporate earnings sure to follow, the Fed over-shooting and the bond market apparently pointing to recession. (Yet) In our view, such anxiety about a recession will turn out to be a head-fake . . . (nevertheless) the summer should present some excellent buying opportunities for equity investors, but first we expect to see some bad news on the economy, attacks on Bernanke for overdoing the monetary tightening – and a market correction of more than a few percent." Plainly, we agree.

Consistent with these thoughts, we remain VERY selective on stocks currently. From a macro perspective we continue to advise investors to "follow the money," as last week
India announced that it plans to invest $1 billion over the next 12 months in Canadian oil sands assets. Obviously this is good news for our portfolios. On a more stock-specific basis, the Focus List Committee recently added 2.7%-yielding Crosstex Energy (XTXI) to the Focus List. Crosstex is analyst John Freeman's top-pick in this sector given its expected 60% plus dividend growth this year, and 50% CAGR for the next two years, all from organic growth projects. We also embrace analyst Bill Crow's Strong Buy-rated Starwood Hotels (HOT), which is in the midst of a major makeover as it transitions from an asset-centric to an asset-light company.

The call for this week: The "Prisoners' Dilemma" gets resolved.


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