Bear With It
There
are few trickier environments than a deeply oversold bear market.
Such a market can rally extremely sharply at any time.
The Naz could easily rally 20%-30% without interrupting the bear trend
down. There are false rallies that make
one think maybe lower rates are finally beginning to take hold.
And then some bit of bad news will make the market re-think and send it
to test or make new lows. Yes, there are
many stocks breaking down and there are short-side profits to be had.
But the problem is that the biggest breakdowns are in stocks coming down
from major topping patterns that will play catch-up very swiftly and then become
extremely volatile. And even those will
rally strongly if a bear market rally takes hold.
So lower-risk opportunities are not very abundant.
I KNOW it is difficult for traders to stay mainly on the sidelines.
But that is still mostly the posture I would recommend.
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the economic front, May Copper continues to flirt with new lows and has made new
lows this latest week. Lumber is looking
more like it’s trying to build a very volatile base.
Eurodollars made new highs yesterday, and bonds are testing a minor
trendline support, but show no breakdown from a major topping pattern as of yet.
Cotton may bounce, but has also made new lows this past week.
Thus, investors should be cautious
and assume that the economic weakness will continue until nearby copper closes
strongly above 85, nearby Lumber closes strongly above 250, AND nearby long
bonds close weakly below 102. Only when
the economic signals become clear should we get excited about a potential market
reversal, I would suspect.
reiterate again and again that the real
key to the stock market will be to watch breadth.
When our Top RS/EPS New High list consistently and substantially numbers
above 20 every day, and when we get a handful or more of stocks that are
breaking out of sound bases that have fuel or very nearly have fuel in a given
week, that’s when we need to sit up and take notice.
Until then, fellow traders, continue to tread cautiously and batten down
the hatches. This bear could be nearly
dead, or he could be with us for another year. We’ll
just have to let the market show us and wait patiently.
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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 eleven-day MA of advances are >1.9 times the eleven-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-plus-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.
On the positive front, it appears that unless there is substantially more
downside action, that the A/D line and a group of value stocks are in a
bottoming phase.
should realize that a KEY variable in unlocking the investment puzzle for this
year will be whether Fed easing will work effectively this time around, or
whether it will only slow the rate of economic deterioration.
Investors need to understand how to monitor this question to determine
how to invest optimally during the course of the rest of 2001.
Let’s explore this debate.
could certainly argue that rate cuts may not have nearly as much of an economic
effect as they have at any time since WWII this time around.
If indeed we have a global capacity glut, a global capital spending boom
has busted, and consumption cannot be stimulated very much from its already high
levels, then the liquidity infusion will not have the effect it has had in the
past in stimulating either the economy or the markets.
fund redemptions are just beginning, and the slide in the markets in response to
them has been fierce. Insiders are
beginning to unload their positions again, as they did in late 1999 and early
2000. Consumer confidence has not yet
weakened to a point of panic — and investors are surprisingly complacent given
the degree of market decline. But another
leg down in equities or a blip up in the unemployment rate may lead to a much
sharper reaction from consumers and investors, leading to a vicious circle.
cotton, and copper, three historically leading indicators of economic
acceleration, are still at or near new lows, giving little hope of a quick
rebound in the economy yet. And the
market seems to be news dominated. Every
time it begins a recovery, some new company announces some sort of
disappointment and the markets return to retreating again.
coming weeks will bring a deluge of earnings reports at quarter end.
So far, the early returns are not encouraging.
And mutual fund investors might be pretty upset come April 15 this year
when they realize that although their growth funds are down 35%-60%, most growth
funds booked long-term capital gains in 2000 that will be distributed to
shareholders and taxes must be paid on. So
mutual fund investors may have to pay taxes on gains in funds which they hold at
a large loss. And option holders in tech
companies may face even worse surprises. The
New York Times recently ran an article about a Silicon Valley exec who
made $3 million on his stock options, but faced an $8 million tax on those
gains. The IRS establishes the cost basis
of options when they are given to the employee, but many employees didn’t
actually sell their shares until much later, when they were worth much less.
There are now a large group of people who are actually being bankrupted
by the tax bill they face on their stock options which are not worth nearly
enough to even pay their taxes! Investor
rage with IRS rules on mutual funds and stock options may flare up this April.
the other hand, so far the economic fallout from the downturn has been fairly
limited. Thus, far businesses have not
sharply reduced payrolls forcing unemployment up and leading to a retrenchment
by consumers. Instead, they have cut back
on other expenses. While the wealth
effect is likely to be negative, it has hit the wealthiest income group much
harder than it has the average American. Recent
consumer-sentiment data suggest that the average American is still spending
strongly and is not overly concerned with the blossoming economic weakness.
Investors are not yet panicking. And
there are pockets of strength in the economy, such as housing and some parts of
the retail market. The Fed has responded
very swiftly to recent economic weakness. We’re
likely to get some fiscal stimulus, in the form of quick tax cuts, and the
energy market is giving some stimulus with declining prices.
IF the Fed loosening begins to take hold before unemployment really takes
off, we might be able to avoid more than a minor recession.
While the recovery is likely to be soft and slow, similar to the 1990-91
experience, a recovery is certainly possible here.
The key is whether the LEI and leading commodity prices can respond to
Fed easing BEFORE unemployment begins to rise sharply and consumer sentiment
moves from concern to panic.
should realize that the difference in market-performance outcome from even a
muted recovery that starts this year, versus the outcome from a deep recession
that persists well into 2002, is substantial. This
will be the key question driving the markets later this year — will liquidity
infusion stave off a prolonged and deep recession or not?
we will be unlikely to know if Fed easing will work until the Fed gets ahead of
the curve in its loosening of policy. Watch
the forward Fed Funds rate markets. Currently,
they are discounting another 50-bp cut by the Fed in May.
When the forward Fed Funds markets begin to not discount any further cuts
in policy, the Fed will be ahead of the curve — and then we must watch for
signs that the economy is turning around, via LEI data and leading commodity
prices basing and moving higher.
classic major bear market usually has a long phase where the markets begin
discounting weaker earnings and a weaker economic environment.
But they also have another later, and often more damaging, phase where
investors throw in the towel on stocks and people need liquidity so badly that
they must sell their stocks at any price to raise needed cash.
In this environment, forced selling by mutual funds facing huge net
redemptions may also play a key role. The
big question now is whether the Fed can correct the economic weakness quickly
enough to forestall this capitulation phase. If
he can, we will have a mild recession and a likely new bull market underway
later this year. If he cannot, then we’ve
got a lot more weak market action ahead of us. So let us all watch the verdict
of the markets VERY carefully from here on in. These
two potential outcomes are VERY different.
suspicion is that the Fed has not yet eased enough to halt the slide in economic
expectations, so that any near-run bounce in stocks will not develop into a new
bull market. However, there are strong
indications that a potentially catchable rally is near at hand.
The VIX, TRIN, and several sentiment indicators have declined to levels
that normally indicate a steep rally should take hold soon.
The Dow has bounced off of a Fibonacci support level on a Fibonacci
turning-point day. Even some valuation
tools that measure the broad market’s PE vs. the 10-year-note yield show the
market to be undervalued. A sharp bear
market rally that takes the Nasdaq up 20% or more from its lows, could certainly
take off at any time. But remember to let
BREADTH be your key to determining if the environment is improving or not!
look at some numbers from the week. New
Highs vs. New
Lows on our RS/EPS lists were 18/39, 25/33, 27/50,
7/116 and 10/85 — which tells us that new lows are dominating fairly
consistently, but are very volatile in terms of their dominance.
No trend is crystal clear. There
were roughly 22 breakouts on the upside to new highs of stocks on our Top RS/EPS
New Highs lists, with 34 breakdowns on
the downside of 4-week-plus consolidations on our Bottom RS/EPS New Lows lists.
Here again, a very bearish market would show more than double this number
of breakouts. Our lone short is down a
bit from last week, and we did have some close calls on the short side, like
Global Crossing
(
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PowerRating) and Adaptec
(
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PowerRating), but nothing met all of our
rigid short-sale criteria perfectly. So
opportunities remain fairly sparse, and in truth, we’re somewhat glad of that in
this treacherous environment. We’ll
remain mostly on the sidelines until stocks meeting all of our criteria appear
en masse.
overall allocation is still VERY DEFENSIVE with 92% in T-bills awaiting new
opportunities, and 8% in short-sales. 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 down
about 2.5%, with a mostly cash position.
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 and course “The
Science of Trading.” 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.
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, and are now as
defensive as possible.
breakouts meeting up-fuel criteria (and still open positions) so far this year
are: none; and last week we had no valid
pattern breakouts up in stocks meeting our up-fuel criteria (see 10-week trading
course). 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.
the downside, 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: Rogers Communications
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PowerRating)
@14.32 (14.02) w/15.25 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. Here, too, remain
cautious by only adding two shorts in a week, until we get more consistency
in the number of downside breakouts in a given week off of our Bottom RS/EPS New
Lows lists.
strategy remains simple and relatively cautious as well:
protect against whipsaws by waiting patiently for real low-risk highly
reliable trades that meet ALL of our criteria. Remember,
our goal to make consistently better-than-market returns (20%+ average annually)
with relatively less drawdown risk than the market.
Smile and think of the carnage we’ve just avoided from the sidelines.
When valid breakouts of up-fuel or down-fuel stocks become abundant
again, we’ll pounce with both hands. Until
then, we must tread cautiously to avoid getting chewed up.