What is the significance of the successful Iraq vote? The first blush was a euphoric declaration of victory, with pre-market equity futures up significantly early Monday am, and Oil softening. The expected monster rally never quite materialized, and oil closed up a buck.

The generalized caution kept the party sober, and this is a good thing.

Why? The successful election in Iraq sets the stage for the next leg upwards in the market, and its (mostly) thanks to sentiment. Have there been any changes or improvements in the fundamentals? Absolutely not — in fact, if anything, the numbers are decaying. The elections in Iraq does not lower P/Es, change our balance of trade problems, lower Federal deficits, increase hiring, stop interest rates from going higher, or eliminate al-Qaeda.

But it is a significant shift from the prevailing sentiment that has gone from excessively exuberant in December – when Bulls were 70% of the AAII surveyed investors – to more Bearish as of late; The AAII reported this week that their member investors who described themselves as Bullish dropped to 26.43%.

What we see happening is the so-called Wall of Worry has been rebuilt; Instead of participants presenting a goofy euphoria to the major major milestone in Iraq, we see the market actually engaging in sober contemplation. Rather than just throwing money at the highest Beta, least profitable stocks, there is a more contemplative investment thesis being deployed.

Recall the last time  caution was thrown to the wind – that was in late December. The prevailing sentiment was extensive bullishness – and the market rewarded that by selling off off for 5 weeks. Now, in the face of good (albeit decelerating) earnings and a positive initial outcome in Iraq, fear and caution rule the markets.

As the nearby chart reveals, this has encouraged the internals to improved markedly – in particular, the SPX advance decline. The downtrend line has been broken, and the longer uotrend in advancers over decliners is still in effect.

To us, that is a recipe for an intermediate term rally lasting 2 to 6 months. Whether this ultimately is the last sucker’s Rally of the cyclical Bull within a secular Bear run is indeterminate at this moment (but if you have been reading me for any length of time, you should know my views on this by now).

Further, the political capital President Bush has acquired thanks to his unexpected triumph via the Iraqi elections, significantly increases the possibility of successfully ramming through Social Security privatization. A few weeks ago, it looked DOA. Now, the odds for some sort of privitization have markedly increased, market participants will be salivating over the fund inflows. Regardless of your views on this “reform,” a few trillion dollars will certainly goose the market. At the very least, for a short period of time – I assume years – until a form of stasis or balance occurs, as markets adjust to this new form of fuel.

We suggest positioning yourself on the long side prior to the SotU address. The next leg up may be at hand.

Category: Markets

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