An Attempt To Bring Back The Bubble: Eight Key Points To Keep In Mind

• July 3, 2003
• Mark Boucher

The year 2003 may well mark a historic shift in
Federal Reserve and fiscal policy that could be similar in magnitude to the
historic shift of the Fed toward fighting inflation by Fed Chairman Volcker (and
then adopted by Greenspan) in the late 1970’s that ushered in the secular
disinflation period.

Here are some key points for
investors to keep in mind:

1. The Fed and global central
   banks as well as most global federal governments seem intent on avoiding the
   Japanese disease of deflation.  The Japanese were so afraid of rekindling
   their asset bubble that they stopped and started fiscal and monetary policy
   stimulus and failed to aggressively and decisively thwart deflation.  
   They were also locked in a Keynesian box and failed to institute market
   oriented reforms in their banking system that would allow bad debts to clear. 
   Both monetary and fiscal policy stimulus was inconsistent and not aggressive
   enough as well as coming late in the game.

    

2. Before WWII, recessions led
   to debt and capital reliquification as bad debts were allowed to fail and poor
   uses of capital led to auctions — while this was painful it allowed the system
   to clear and start anew.  However since WWII every recession has been fought
   by the Fed with excessive artificial monetary stimulus aimed at preventing a
   collapse of the debt structure.  This remedial monetary stimulus aimed at
   stabilizing a crisis and ending recession did not allow bad debts to be
   liquidated and cleared as would occur in a free market, and so it encouraged
   borrowers to take on more debt.

    

3. The central bank  “solution”
   to recession of stimulating more debt assumption via artificially lowered
   interest rates has created a narrower and narrower band for policy in each
   successive recession, with deflation on one side if policy is not stimulative
   enough, and inflation on the other if policy is too stimulative.  Policy
   makers are getting to the point that they are forced to inflate to extremes in
   order to get consumers and businesses to take on more debt and avoid debt
   deflation which would destabilize the entire financial system.  Debt levels
   have never been so high, and therefore the risk of deflation has never been so
   extreme.  The irreversible debt (death) spiral is falling price levels
   combined with high debt levels — for this means the collateral behind loans is
   declining in value and debt becomes impossible to pay off in full.  This
   combination of high debt levels and declining prices creates a deflationary
   combination that is almost impossible to stop once it is started. 

    

4. Deflation would destabilize
   the entire debt structure, the bedrock of the so-called “modern economy.”  It
   is therefore politically and socially unacceptable, so it is being fought
   tooth and nail by massive fiscal policy stimulus as well as hyper-stimulative
   monetary policy, and an announced “soft dollar” policy.

    

5. But now that interest rates
   on mortgages are unlikely to go much lower as bondholders catch-on to this
   huge shift in policy, consumption growth will be unsustainable without an
   increase in corporate profits.  The Fed hopes to bring back pricing power by
   engineering higher inflation rates that will help corporations raise prices
   and profits.  Thus investors should expect a gradual upswing in inflation in
   the years ahead as the most likely scenario of this policy dilemma.

    

6. Yet the swing from deflation
   and disinflation to inflation will take some time and there will be a time lag
   before the policies in place produce inflation in actual measured economic
   variables.  This environment is one of significant instability.  Markets can
   become explosive once opportunity and direction are recognized and capital
   rotates to a favored asset-class or sector, creating mini-bubbles that can
   shift very quickly, only to leave investors stranded who do not shift rapidly
   to the next area, as almost no move is sustainable in the long run.  
   Eventually interest rates will wake-up and rise high enough to choke off the
   recovery and inflationary pressure.  Yet there is likely to be a significant
   lag between the new policy and the popping of the bond market bubble via
   substantially higher interest rates.

    

7. If policy is successful at
   engineering inflation, which is by far the most likely intermediate-term
   outcome, then one would have to suspect that stocks will become a focus of
   speculative activity again.  If it takes more than six months for rates to
   choke off the recovery, stocks could retrace 50%-75% of the entire decline
   since 2000 in a mini-bull-bubble environment.  Bonds are a bubble now, and
   though they may hold up until it is clear that global economic weakness has
   abated, investors should be shifting out of them.  The dollar is likely to
   continue to decline, and since Asian currencies are tied to the dollar, most
   of the pressure will come versus the Euro and commodity currencies.  Asia will
   be a prime beneficiary (as will Emerging Markets in general) of any economic
   uptick.  Gold should embark on a long-term bull market in this scenario.  Real
   estate may also become the focus of speculative bubble like activity until
   rates rise enough to choke things off.

    

8. But, investors need to be
   aware that the TERMINAL decline in the stock market (and possibly economy and
   real estate) could well be brought about by the eventual bursting of the
   current bond market, and by high interest rates choking off the new policy
   toward inflation much more quickly than during any previous cycle.

    

The bottom-line is that the
period ahead should witness aggressive central bank and fiscal action that will
lead to brief mini-manias.  Investors will have to be extremely flexible and
very nimble to do well in this environment.  As always, watch for confirmation
by breadth and internals before moving into any asset class aggressively — and
be ready to pull the plug on nearly any stock investment at a moments notice.

Right now the internals are confirming a mini-bull scenario.  The leading
sectors continue to be biotech and medical related, telecom and Internet
related, Home building/RE/Mortgage, Natural Gas and software.  Small-cap value
is the leading segment of the market, which is consistent with the pre to
beginning inflation part of the cycle (late cycle).  Downside leadership for
shorts is barely existent.  Globally leadership is coming from China, Thailand,
India, Eastern Europe and Russia, commodities and resources, and Latin America
(Emerging markets in other words!).  Gold stocks are also climbing the relative
strength board impressively.  Global Breadth is confirming a higher trend in
equity markets.  Nearly all of the 48 countries we follow have their indexes
above 200-day moving averages. 

Investors should note that the markets this week found support just above the
levels we indicated were critical for gauging whether the market was correcting
or consolidating in last week’s column.  The S&P was not able to close below 970
although that level was tested intra-day, the Dow bounced just above the
critical 8940 level, and the Nasdaq also bounced just above the critical 1590
level.  Thus we’re still in a consolidation and not a correction, which is
positive, particularly if we can breakout from here.  Continue to watch for
strong volume closes below all three — 970 S&P, 8940 Dow, and 1590 Nasdaq as a
signal that a more serious correction is developing.  Also now watch for a
strong volume close by all three above 1025, 9375, and 1700 respectively to
confirm a new leg up.

Investors should continue to cautiously add stock exposure as trade signals are
generated. Wait for high volume, strong breakouts of the S&P and Dow new 52-week
highs before to become more aggressively bullish. All of the conditions are in
place for continued stock market strength with the lowest treasury yields in 50
years; now we await to see if the market can show further follow through and
breakouts that meet our strict criteria.

Our model portfolio followed in TradingMarkets.com with specific entry/exit/ops
levels from 1999 through May of 2003 was up 41% in 1999, 82% in 2000, 16.5% in
2001, 7.58% in 2002, and we stopped specific recommendations up around 5% in May
2003 — all on worst drawdown of under 7%. 

Last week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 27, 32, 33, 21, and 46 in our Top RS/EPS New Highs list,
accompanied by just 3 breakouts of 4+ week ranges, no valid trades, and close
calls in
(
RTLX |
Quote |
Chart |
News |
PowerRating),
(
DRIV |
Quote |
Chart |
News |
PowerRating), and
(
GLDN |
Quote |
Chart |
News |
PowerRating).  With new daily highs again above 20 the market
has a shot at continuing the rally as long as these hold up.  The action
continues to rate as cautiously bullish biased, but nothing like that of the
great bull markets of the 1980’s or 1990’s.  On a major secular bull move we
would see 100’s of breakouts in close calls or stocks meeting our criteria, not
just 2.  Remember to try and position in valid 4 week trading range breakouts on
stocks meeting our criteria or in close calls that are in clearly leading
industries, in a diversified fashion.  Bottom RS/EPS New Lows remained
non-existent last week, as they have been since mid-April, showing low readings
of 4, 0, 3, 3, and 2, with 2 breakdowns of 4+ week patterns, no valid trades,
and no close calls, so the short-side remains muted. 
Continue to watch our NH
list and buy flags or cup-and-handle breakouts in NH’s meeting our up-fuel
criteria that are in leading groups, but add no more than two positions a week.

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge, my course “The
Science of Trading,”

my video seminar, where I discuss many
new techniques, and my latest educational product, the

interactive training module. 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
U.S. 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 long 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 of change in the
new-economy/old-economy theme appeared to be upon us. We’ve been effectively
defensive ever since.
On the long side we like
(
AVID |
Quote |
Chart |
News |
PowerRating) and
(
UNTD |
Quote |
Chart |
News |
PowerRating) still and the close calls of this week
were DRIV, GLDN, and RTLX.  No short-side opportunities have developed via our
strategy for some time.    We also like conservative gold stocks, like FCX pfd A
and NEM, some broad EM exposure like DEMSX, Eastern Europe, China, and Thailand,
in particular. 

Wait for breadth and technicals to confirm that the liquidity infusion is going
to have some traction, or that a more meaningful correction is upon us. 
Pare your weaker holdings here and wait to rotate into new breakouts once this
consolidation/correction is over. Investors should remember to wait for valid
breakouts of stocks meeting or close to our rigid criteria before buying.  We
continue to watch for clear leadership in leading new industries and plurality
of breakouts in those industries, for follow-through by close call and criteria
stocks, for breakouts by the averages that will confirm if this bear-market
rally has legs, and for further breadth thrusts, to tell us that a better
bullish cycle is developing here. 

Mark Boucher