Anatomy Of A Pullback

March 29, 2002
Mark Boucher

In
textbook style, resistance in nearly all of the major averages
stalled the rally that was initiated in early February. The resistance proved to
be quite reliable, having been tested a number of times and coinciding with key
Fibonacci levels and dates. Small-cap stocks continue to outperform and were
least affected by the existence of overhead supply on the charts.

The Russell 2000 continued to
advance this week, albeit gradually, while the broader averages pulled back, the
S&P having reversed at well-defined resistance around 1180, while the
Nasdaqâ€™s run failed a bit below resistance in the 1800-2000 area. The Dow has
been somewhat of a leading indicator this year, and it appears to be finding
support within its trend channel around 10,300 where there was once resistance.
Best-case scenario would be for the market to follow the industrialsâ€™ lead and
eventually break through these important resistance levels.

A pullback is
nothing to be concerned about, but investors should be prepared to expect fewer
opportunities to take new positions. Naturally, not that many stocks will be
hitting new highs and breaking out, so breadth will wane a bit as the market
consolidates. As of yet, there hasnâ€™t been a lot of volume pouring into the
market, which is a good thing because heavy activity on a pullback suggests
distribution. Rather, things are seemingly quiet, which is characteristic of a
classic pullback within a primary uptrend or trading range. Only if we see a
break of support would the correction raise any kind of red flag, and right now
support is far away from current levels in most of the major averages.

Even more important
than the action of the major averages is the action of the leadership of this
rally. As long as Asia, Eastern Europe, Latin America, and small-cap value are
holding up fairly well, undergoing consolidations and not corrections, then the
longer-term move looks healthy. Continued
moves up by commodities and commodity currencies will also be encouraging.
The major averages are followers in this global rally, not leaders.

Of course, a
breakout through resistance levels by the major averages would be a very bullish
indication. It is the missing link with the ever-broadening plurality of
commodity, commodity currency, and foreign stock markets already confirming the
recovery/brief-bull-market scenario over the intermediate term. When the major
averages convincingly hold support and begin to rally again, keep your eye out
for an improvement in breadth, such as:

A 9:1 up/down
volume day

The five-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

We may not see any
of these factors fall into place because the bull move will probably not garner
the same strength it has in the past. Remember that the U.S. market is only
likely to correct 50%-68% from here to its 2000 peak levels â€” not make a new
high. The major averages are starting a
bull move from valuation levels normally associated with an end to a secular
bull move. This market clearly looks and
acts like the mini-bull markets of 1965-1982, not like the secular bull moves of
1982-1999. Even so, things are positive enough to allow more than two stocks per
week to be added to the long side IF we have
the opportunity to do so in the names on our new highs list.

While we are always
encouraged to think globally and act locally, right now you may want to consider
thinking locally and acting globally as the rally in global markets spreads.
This means being aware of the breadth statistics in the U.S. market, while
holding a portfolio that will benefit from the global recovery. We would
recommend reviewing funds with regional and global exposure to outperforming
sectors such as small-cap value. The best relative strength around the world is
in Asia (x Japan), Eastern Europe, Latin America, and is now spreading to
developed nations everywhere.

The biggest problem
with most European developed markets is that value is not very good, although it
is better than in the U.S. In emerging markets, value is good and appreciation
potential and earnings growth changes are much better. So the stance should be
neutral on most developed economies and overweight those that we have been
mentioning for several weeks in this column like emerging Asia, Latin America,
and Eastern Europe. Itâ€™s true that the U.S. is the easiest market to watch
closely because of the availability of data, but remember that breadth and
momentum are as important globally as they are locally and that this is where
the action is right now!

Commodities are
still rallying and are becoming more and more bullish. We have seen minor
breakouts in the Australian and New
Zealand dollars. Copper, Nickel, and
Zinc are trending nicely within the confines of an uptrend
channel. Lumber had a bad week and is
testing the steadfastness of its uptrend, but has not yet broken down. Overall,
the CRB Index reveals that commodities have
been improving, which confirms the global recovery scenario and makes the
prospects for a meaningful economic upturn rosier. With commodity prices moving
off their bases, economically sensitive currencies showing strength, and global
bonds heading lower, our posture is slightly bullish in our model portfolio.

This week we had one
close call in Mid-Atlantic Medical
(
MME |
Quote |
Chart |
News |
PowerRating)
which broke out of a four-week consolidation pattern, but still no new trades.
Volume simply isnâ€™t there on the few breakouts that we have gotten. As it
becomes clearer that this mini-correction has run its course, we would expect to
see more opportunities develop. Wait for them before increasing exposure — and
ONLY in leading groups!

Top
RS/EPS New Highs couldnâ€™t even manage to break the 20-per-day mark that we
watch for (16, 16, 15, 8, 20) and breakout numbers were even worse than last
week, with only nine for the week, and most without the volume that serves to
confirm reliable breakouts. We were stopped out of one position in Coventry
Health Care
(
CVH |
Quote |
Chart |
News |
PowerRating), but with only a small loss given the placement
of our protective stop. There has definitely been an improvement in relative
strength in medical- and health-related groups, but we have yet to get a good
trade out of it, which raises the question of whether we will see follow
through. There were only 28 Bottom
RS/EPS New Lows this week, which is a good thing from a macro perspective,
but does not allow us to add any short positions to our model portfolio.

Our overall
allocation remains SOMEWHAT DEFENSIVE, with 76% 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 â€” all on a
worst drawdown of around 12%. Weâ€™re now up about 1.5% for the year 2002.
We still think that our long/short strategy in growth stocks with decent value
will be able to show good returns this year. But realize the U.S. market is
likely to be volatile, and our approach will not be able to avoid some of that
volatility â€” so expect more frequent and larger drawdowns than weâ€™ve had so
far.

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 an environment
unclear directionally, we also 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.

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: NONE. 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.

Again we encourage
investors to act globally and become more active in emerging markets and
gradually in developed nations. The U.S. market needs to clear its resistance
levels to become more bullish than we have been. This may not happen for weeks
or even months and may need a catalyst such as the Fedâ€™s announcement in May.

Anatomy Of A Pullback

BUY THE FEAR, SELL THE GREED

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