Bear Breadth Slows Markedly

In
terms of the numbers of new lows on our Bottom
RS/EPS new lows list published daily on TradingMarkets.com, bear
market breadth appears to have peaked. This
does not mean that downward pressures are
over, just that they have eased up a bit from the crash-pace that
followed the terrorist attacks and delayed openings. On
the plus side, European markets have rallied a bit vs. the U.S., and
this week’s only significant rally came on the heels of a European
market recovery, so the decline in percentage terms in Europe vs. the
U.S. is converging, as we speculated on in
last week’s column.  

The
first thing the bulls have to look for is a good follow-through day on
the upside. Initially, we
should not expect more than an intermediate-term rally ala April-July
of this year or May-Sept of last year to erupt off of any bottom made
in the next couple months. We
continue to suspect that a sustained rally is unlikely until economic
growth is more assured and the uncertainty over the response to the
attack is clearer. 

Economically
sensitive commodities remain bearish. Copper
and Cotton are barely bouncing off of new lows, bonds are moving
toward new highs, and the one strong holdout, Lumber
is now approaching its January lows again after completing a huge
Double Top formation. Commodities
are discounting recession with no recovery yet in sight.
We suspect a sustainable rally in stocks will not develop until
we get clear bottom formations and upside breakouts in copper, lumber,
and cotton, and U.S. bonds begin to top-out and break down. Right
now, these markets are discounting further economic weakness.

As
a reminder here are some more breadth gauges to watch carefully, as we
have suggested many times since March 2000.
Look for two or more of the following breadth
tools to indicate a possible strong leg up before getting too
excited about buying stocks again: 

1. The
   five-day MA of up volume being greater than 77% of the five-day MA of
   total volume on a day after the low has been made; 

2. The
   11-day MA of advances are > 1.9 times the 11-day MA of declines; 

3. Up
   volume/(up volume + down volume) is > 90% on a given day; 

4. The
   S&P rises by 2.75% or more on a given day and 70% of issues traded
   advance on the NYSE; 

5. After
   the fifth day following a market low price, we get a strong
   follow-through day, a day where two or more of the major averages are
   up more than 1% on volume that is up from the prior day and at least
   20% above the 50-day ma of volume; 

6. Finally,
   and most importantly, that we get a large number of breakouts to new
   52 week highs by stocks that are strong EPS and strong RS leaders
   breaking out of bases that are 4+ week solid bases on strong volume.

Investors
are advised to wait for at least two of
the above breadth criteria to develop before beginning to increase
equity allocations significantly. Give
the bear the benefit of the doubt for a while here. 

Our
overall allocation is now DEFENSE with
76% in T-bills awaiting new opportunities.
Our
model portfolio followed up weekly in this column ended 2000 with
about an 82% gain on a 12% maximum drawdown, following a
gain of around 41% the prior year. 
For year 2001, we are now up about 14.69%, with a heavy cash
position.  Last week
was actually one of the best we’ve had in our model portfolio from the
crash in GX and (PD),
and despite a stop-out with a loss in (SBAC). 
However we are taking profits on (GX),
and reducing our exposure again.

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
4-week or longer flags, or of valid cup-and-handles of more than 4
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 4+week flags or cup-and-handles on the
downside.  In an
environment unclear directionally, we also only buy or short stocks on
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 upfuel 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 NH’s
meeting our up fuel criteria — but continue to add just two per
week, and only in leading groups

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: (GX)
@6.05 (2.41) — now take profits at 2 or lower; (PD)
@38.1 (27.61) — now use 35.5 ops; (BRP)
@31.69 (23.2) w/ 26.5 ops; and (SBAC)
@12-stopped out on 14 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.
The oversold nature of the market leads us to suggest that
investors remain cautious by only adding two
shorts in a week. The
problem is that with VIX and TRIN signaling very oversold levels, we
can get short-covering rallies that stop us out of everything very
quickly. Don’t double up on any
industry until you have a break-even or better ops in any other short
issue in the same industry.

We
still suspect that either new lows or a retest of recent lows will
develop over the next 10-20 weeks until solid evidence of recovery
begins to emerge. But let’s let
the market show us with follow-through days and other breadth measures
if a really playable rally can materialize off of this fall’s lows.
Until we get a couple follow-through days, the benefit of the
doubt belongs to the bears and to being cautious.
Let’s be patient and watch what happens with the recession and
new war on terrorism, while paying super-close attention to clear
market reactions to events.