Stocks Climb Again - It is Umpa-Lumpa time

The Dow Jones Industrial Average (DJIA) made an all time high on Friday (Oct 13) reaching 11,960.51. The bulls seem to be in total control for now. Several theories are floating around as to why the market is trading at new highs despite the slowing economy.

• Increased liqudity in the market (an increase in M3 Money Supply i.e. institutional money funds, large time deposits)
• Lower gas prices (crude oil falling from $78 a barrel in August to the current $59 level)
• High short-interest on the NYSE (short squeeze)
• Rally in large-cap stocks (several large caps are undervalued)

• Increased consumer spending
• The Federal Reserve will start to lower short-term interest rates
  

So, what happened to the Iraq war, the North Korean nuclear test, the Iran nuclear stand-off, the huge US current-account deficit, upward trending US interest rates, and last but not least the correction in the US real estate valuations?

Investors seem to be marching fife and drum, with nary a glance at the geopolitical and fiscal environment. Since August 2006 the DJIA has increased by 10.75%. (incredible)

I find it hard to believe that a reduction of $1 per gallon at the pump (although significant) over less than a couple of months has suddenly made the US consumer feel warm and fuzzy. The strength in the retail sector is really puzzling. Several of the specialty retailers are showing double-digit growth in same store sales and continue to make new 52-week highs. Look at the charts of the following companies:

• American Eagle Outfitters (AEOS)
• Abercrombie & Fitch (ANF)
• Dicks Sporting Goods (DKS)
• Nordstrom (JWN)
• Guess (GES)

In my opinion these stocks are starting to look overvalued. American Eagle Outfitters (AEOS) was a great stock to own at the beginning of the year ($21) but with about a 120% gain in the stock price, I think the party might just be getting over and the stock is probably due for a pullback.

Some stocks such as

• Under Armor (UARM)
• Coldwater Creek (CWTR)
• Zumiez (ZUMZ)

are just behaving like the .com stocks of 1999. Is this price appreciation driven by strong and sustainable fundamentals or, is it merely an year-end window dressing charade of the mutual fund managers? Whatever it be, I guess Wall Street will always have a reason.

So where do we go from here? The benchmark indices may continue to set new highs (although the Nasdaq might have to wait a few more years) running up to the mid-term elections in November. However, the market is certainly setting itself up for a scary time this Halloween season and the "Umpa Lumpa" might just show up to take away the spoilt investor.

On that note, I would consider investing in the following:

• Buy at-the-money put options for May 2007 on AEOS, ANF, UARM

My rationale for these recommendations are:

• These stocks are overvalued and over-extended;
• Consumer spending may not hold up into next year (reality will set in when investors come to grips with the sharp correction in property values)
• Money is no longer cheap (Fed has increased interest rates 17 times since 2004)
• I don't think we will see $40/barrel oil in the near future

Disclosure: I own puts on American Eagle, Abercrombie & Fitch, Dicks Sporting Goods