Action Needed To Restore Global Equity Rally And Global Recovery

And, as we’ve discussed
before it hit the major news sources, war risks continue to expand.
Bush is tirelessly pushing for UN or Congressional room to attack.
The Democrats want to delay this until after the election, but they are
starting to realize that acting so clearly political could not help at the
polls. The intelligence information
regarding Iraq’s ties to the 9/11 crisis and his accumulation of nuclear
(that’s nuclear, not nucular, Mr. Bush!) is totally shocking and compelling
and argues for nearly immediate attack. However,
the Bush team is hesitant to release intelligence to the public or to the news
media because it will give clues as to its sources, which would tear down needed
intelligence sources in the war ahead. So he is slowly releasing enough to Congressional
leaders to melt opposition down slowly.

It is clear from the Crawford
Meeting that Bush would prefer to attack between now and late October.yes”> This means the attack could take place anywhere between now and
early the second quarter next year. Early
next year the weather improves for an attack. Thus,
the markets are getting their worst case scenario in terms of war risks —
massive uncertainty. A strike will need
to successfully isolate Saddam within two to three weeks to push markets ahead,
if it does develop. But while the markets
must wait for the hat to drop, it is unlikely that they will be able to undergo
a serious or catchable rally.

As we mentioned last week, sometimes
knowing when the odds are not that great, to hold back investment is as
important to long-term gains with limited risk as is knowing when to invest
aggressively with high reliability. The
risk/reward of significant market exposure to us now is unfavorable on either
the long or the short side. The
combination of tentative market signals, poor clarity in non-equity market
signals, poor leadership, questionable macro signals, and
political/terrorist/war risks, lead us to remain very cautious with respect to
both the long and the short side of the US equity market.
If leadership and broader breakout participation can develop, then this
rally may develop into something nicer than investors have seen for nearly two
years. If leadership doesn’t develop,
we may get another leg down before a catchable rally is upon us.

Therefore we continue to
suggest investors wait and watch for more indications of better breadth on a
large number of fronts. Look for more
strong rally days on ABOVE average volume. Watch
for another breadth thrust up, like:

• Another 9:1 up/down volume
  day

• The 5-day moving average of
  advancing volume to be 77% or more of total volume

• An 11-day A/D ratio of 1.9
  or more

• Or a 10-day A/D ratio of 2
  or more.

The market is no longer
rallying on negative news, and negative earnings numbers are weighing on the
market. That needs to turn around before
a good rally can develop.

Foreign markets are now
weakening and/or dropping to new lows. They
need to turn around and participate in a global rally before a significant one
in the US should be expected. Commodity prices need to
react not just to shortages and war fear, but to stronger demand for a real
recovery to become evident. Bond prices
need to begin to retreat off of very overvalued levels in response to expected
stronger economic growth before the recovery is more certain.
Junk bond spreads need to narrow sharply as expectations move toward
companies being able to pay their debts because of a better economy, before the
market or economy are showing clear signs of
a better environment.

And we believe it is now
getting clearer that we will also need clearer signs of concerted global
monetary stimulus and a Fed rate cut before the stock and economic environment
improve dramatically enough to warrant the risk of substantial long equity
allocation. Most importantly, wait for a
much larger number of new highs on our lists and breakouts of valid four-plus-week
consolidations in stocks that at least almost meet our criteria before thinking
of allocating aggressively to this market.

Until we get substantially
better evidence of a potential rally, our strategy remains ultra defensive, but
continues to slug out small gains. Since
March 2000 the world index is down over 45%, the S&P over 48%, the IBD
mutual fund index is down over 62%, and the Nasdaq has crashed over 76%.
Meanwhile, since March 2000 the long/short strategy we summarize and
follow-up each week in this column has made more than 38% on a worst drawdown of
under 6%. While this
performance is certainly underperforming our long-term growth rate, and it is
hardly thrilling to have been so heavily in cash since March of 2000, we have
managed to eke out gains with very low risk in a very dangerous market
environment where 9 out of 10 traders have been big losers.
We will hope and watch for a better environment, but wait patiently until
it arrives before risking significant capital.

Our official model portfolio
overall allocation remains EXTREMELY DEFENSIVE. We’re
now 88% in T-bills awaiting new opportunities. Our model portfolio followed
up weekly in this column was up 41% in 1999, up 82% in 2000 and up 16.5% in 2001
— all on a worst drawdown of around 12%. We’re now up around 6.1% for
the year 2002. Let’s wait for a bit
better environment before positioning heavily.

Top
RS/EPS New Highs never mustered up one
single solid week of consistent +20 or higher readings since the 7/24 lows, and
last week showed marked deterioration. Readings
this week were 9, 6, 11, 9 and 5 with only a pathetic number of two breakouts of
four-plus-week consolidation patterns and no close calls.
Bottom
RS/EPS New Lows did move above 20 consistently this week, with readings of
29, 43, 45, 64 and 99, accompanied by 25 breakdowns of four-plus-week
consolidations, one valid short sale in Bowater
(
BOW |
Quote |
Chart |
News |
PowerRating), and several close calls.

For those not familiar with our
long/short strategies, we suggest you review my 10-week
trading course on TradingMarkets.com, as well as in my book The
Hedge Fund Edge, course “The Science of Trading,” and new
video seminar most of all, where I discuss many new techniques. Basically,
we have rigorous criteria for potential long stocks that we call
“up-fuel,” as well as rigorous criteria for potential short stocks
that we call “down-fuel.” Each day we review the list of new highs on
our “Top RS and EPS New High List” published on TradingMarkets.com for
breakouts of four-week or longer flags, or of valid cup-and-handles of more than
four weeks. Buy trades are taken only on valid breakouts of stocks that also
meet our up-fuel criteria. Shorts are similarly taken only in stocks meeting our
down-fuel criteria that have valid breakdowns of four-plus-week flags or cup and
handles on the downside.

In the US market, continue to
only buy or short stocks in leading or lagging industries according to our group
and sub-group new high and low lists. We continue to buy new signals and sell
short new short signals until our portfolio is 100% long and 100% short (less
aggressive investors stop at 50% long and 50% short). In early March of 2000, we
took half-profits on nearly all positions and lightened up considerably as a sea
change in the new-economy/old-economy theme appeared to be upon us. We’ve been
effectively defensive ever since.

Upside breakouts meeting
up-fuel criteria (and still open positions) so far this year are: NONE.
Continue to watch our NH list and buy flags or cup-and-handle breakouts
in NHs meeting our up-fuel criteria — but be sure to only add names that are in
leading groups, and now only add two trades per week once again until the market
environment improves.

On the short side this year,
we’ve had breakdowns from flags (one can use a down cup-and-handle here as well)
in stocks meeting our down-fuel criteria (and still open positions) in: Applera-Celera
Genomics
(
CRA |
Quote |
Chart |
News |
PowerRating) @9.09 (8.35) w/9 ops;
and new short in Bowater
(
BOW |
Quote |
Chart |
News |
PowerRating)
@37.5 (37.5) w/40.5 ops. Continue to watch our NL list daily and to short any
stock meeting our down-fuel criteria (see 10-week
trading course) breaking down out of a downward flag or down
cup-and-handle that is in a leading group to the downside but only add up to two
in any week (and only in the weakest groups) until we get better breadth numbers
on the downside and better leadership (which is beginning to develop).

There are times when the
environment is very clear and risks are limited.
Unfortunately, this is NOT one of those times.
It is unclear whether the Fed and other major central bankers will now
ease in time to prevent another renewed market decline and further deflation
globally. Will such further easing take
prolonged effect on the economy, or will it be as temporary as previous cuts?

There is the increasing risk of
war and substantial uncertainty of the outcome of such a conflict.
Will more of the Arab world join the fray?
Will Saddam set off a nuclear, biological or chemical weapon before he is
ousted from the world stage? What will be
the effect if he does? Will the US-led
forces oust Saddam from power quickly enough to prevent him from doing damage
via weapons release, and will this restore faith in US and global authorities,
or is this yet the next step in an ongoing war on terror that doesn’t have
clear enemies?

The Treasury department is now
attacking hedge funds, one of the few bastions of unregulated investment and one
of the only investment themes that have potential to profit in this uncertain
environment. Will they cut off growth and
potential in their new aim to try and put an identity on every dollar in the
global economy? And will they turn a free
market system into a fascist centralized one in the name of fighting money
laundering? Investors are advised to wait and watch carefully for a more
reliable market environment. Until then,
the potential gain from breakouts is not worth the risk in my opinion.
We will continue to try and navigate these treacherous markets aiming for
decent gains with relatively low-risk and safety.
Please stay tuned, now more than ever, and emphasize the importance of
patience.