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December 5, 2005

Shot Across the Bow

Stocks started the week with a slump as major indices opened lower and stayed that way. With the exception of the first hour, which showed us most of today's downside, the action was rather ho-hum. It would be dangerous to read too much into today's results since nothing seemed to happen with much decisiveness. However, given clues from other markets, we have to wonder if the weakness was not a warning shot by the bears.

Both the dollar and long bond continued their recent slump. Should the "consolidation" in these two assets turn into a "downtrend", it would be very bearish for equities. If they can turn and set new, near-term highs, it would be bullish. Given gold's continued rise, I think the odds favor a downtrend formation.

Breadth indicators in the market, particularly in the Nasdaq, are continuing to betray weakness. Tops, however, take weeks to form. The underlying weakness may not gain enough strength to drag down the market until more new highs are set. On the other hand, I've noticed that almost no one seems to think the market will fall right now. Even perennial bears, freshly burned by November's vertical leap, are hedging their proclamations. In addition, Google, the epitome of spec stocks, is putting in a formation that looks suspiciously like a top. Although I don't like weighting the performance of "bellwethers" too strongly, Google's performance has strong, psychological value to the market. The stock will need to gain new life if this rally is to be sustained.

In the energy arena, oil was making some headlines today for cracking $60 for the first time in a month. On both daily and weekly charts, oil appears to be threatening an upside breakout after a 4-month slide. The oil market is very good at conveying false signals, so we have to wait for something more definitive to play it aggressively. In any case, I opened a small position in an exploration company which I have traded successfully in the past, Encore Acquisition. EAC is loaded with positives that make it a desirable long trade in energy. The company has a proven management team, their reserves are all located inside the United States, and they increased their known reserves figure by nearly 30% earlier in the year. They also boast a return on equity of over 20% and were profitable even before oil broke above $30. Given these strengths, I believe the company will be a likely acquisition target at some point in the future, though probably not any time soon. Within the next year, I will be looking to build a core energy portfolio, and EAC will be a substantial part of it.

Disclosure: EAC


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