For The Market To Rally, These Factors Must Come Into Play

• May 28, 2004
• Mark Boucher

Macro Trends
Dominate

For equity investors, it is
more important than ever to focus on macro trends as opposed to micro trends. 
The current environment is very difficult for micro-focused investors to
maneuver because most company specific news continues to be very positive, yet
the markets are in the doldrums.  Earnings are rising as are earnings
expectations, companies are beginning to invest more in capital equipment and
R&D, and now payrolls are growing as well.  All of the liquidity that the Fed
has pumped into the economy in the past two years is really working, assuming
payrolls continue to increase.  Unfortunately, for the market to rally, the
following interconnected factors must come into play.  Energy prices must fall
from current levels.  The consumer discretionary sector has been hit
specifically hard because money is being taken from discretionary income to pay
for staple energy.  A pause in the bond bear market would also be a positive
catalyst for the market.  Current bond market expectations are for a 25 basis
point increase at the June Fed meeting followed by three additional 25 basis
point increases by the end of the year.  If inflation fears subside from current
sentiment, the Fed could come out with more amenable interest rate policy that
could give the equity markets a catalyst to rally back near yearly highs. 

Visibility is very opaque in
the markets and will continue until there is a more certain macro-economic
sentiment.  In such uncertain times when the market is having difficulty
differentiating between economic growth and inflation, we recommend that trend
followers keep tight stops on current positions and wait for more certain
intermediate term trends to be established before taking new positions.  

Although we remain extremely
cautious during this time period with equity allocations, we do like spread
trades with the strongest groups spread over the weakest groups.  Currently, the
strongest groups are all staples including Food, Transportation, Medical,
Energy, and Internet Content.  The weakest groups are cyclical in nature
including Finance, Consumer Discretionary, Semiconductors, Computers and
Software.  Keep in mind that the current trend with the strongest groups over
the weakest groups is a bit extended.  Mutual Fund inflows have continued to
supply the stock market with buying power.  Inflows were $23.3 billion in April,
up from $16.0 billion in March.  If equity investors are given the necessary
catalysts to be more aggressive such as falling inflation fears, more lenient
Fed policy, and dropping energy prices, the trend could reverse quickly, and the
increased liquidity would likely flow directly into cyclicals.  Emerging markets
have already begun to improve aggressively from the recent correction, and
further follow-through in this up move could be a further sign that equities
will rally.  Additionally, bond upgrades outnumbered bond downgrades for the
first month in four years, and corporate bond spreads have begun to narrow over
government bonds.  In an environment in which corporate spreads are narrowing,
equities become much more attractive.

So far our US long/short model
has been relatively inactive during 2004, and we continue to suggest investors
use some caution until stocks meeting our criteria expand in breakout breadth. 
Investors should continue to cautiously add stock exposure as trade signals are
generated that meet our strict criteria, as well as allocate to our favorite
segments on breakouts and signals as advised above.  This week we had one close
call from the chemicals group, ROG.  Look for the chemicals sector to outperform
if crude oil prices drop below $35.  Another attractive group that we are
beginning to watch for upside breakouts is railroad stocks, including BNI, NSC
and CSX.  When coal shipments are strong, as they are currently, railroads
outperform.  With our model portfolio having been essentially in cash since
November, it has been frustrating for many — but market environments like March,
April and May make this position seem wise.  These are tough markets and traders
must be nimble and willing to wait for good odds to risk capital.

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 (strict following of our US only methodologies should have had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.   This did not
include our foreign stock recommendations that had spectacular performance in
2003. 

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, and did not get to a fully allocated long exposure even
during the 2003 rally. 

Mark Boucher