Goodbye Deflation Fears, Hello Inflation Fears

December 12, 2003
Mark Boucher

Mark
Boucher is traveling today so his staff is filling in this week, telling you
where they see the market positioned and how to best take advantage of current
trends. Hopefully, all of you have had a very profitable year and your biggest
problem is what positions you are going to liquidate so that you can pay taxes
on all of your capital gains!

The evidence of inflation has had a real effect
on the market this week, and investors should look to invest
in sectors that will benefit from increasing inflation, such as energy and mining.
Today, the US producer price showed a continued increase in the prices of intermediate
and finished goods. This trend will continue as long as the dollar continues
to weaken and commodity prices continue to increase. Import prices for consumer
and capital goods have even begun to increase, which we havenâ€™t seen since
1996.

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Astute investors noticed
the Fedâ€™s changed attitude towards the potential for deflation at this
weekâ€™s FOMC meeting. The Fed stated that an unwelcome fall in inflation
has diminished in recent months and now appears equal to that of a rise in inflation.
The consensus is now beginning to forecast a Fed rate hike sometime in the second
quarter of 2004. The most interest-rate-sensitive groups, homebuilding and mortgage
lending, broke down this week after Washington Mutual dropped forecasted earnings
because of a noted drop in mortgage financing. Watch this area of the market
closely in the first half of 2004. If inflation and therefore interest rates
rise, we may see a correction in the markets, as we have been watching for some
time now. Such a stage of events could stop the liquidity-induced recovery some
time in the latter half of 2004. However, if global bond prices can remain relatively
strong, the global economic recovery could continue for much longer.

We continue to watch the
transition from a liquidity and deficit induced recovery to a profit-driven
upmove in the markets. Profits have improved dramatically since the nadir of
the bear market, but it remains to be seen if profits will continue to improve
now that companies have cuts cost, increased efficiency, and now may have to
contend with higher interest rates once the Fed begins to tighten monetary policy.
This is essentially a transition from phase one to phase two of a normal three
phase cyclical bull market â€” though the present environment is a mini-version
of a normal cyclical upmove. Normally the market experiences a decent correction
of 10% plus during such a transition. Whether this will occur fairly soon or
following one more leg up, we have yet to see â€” but keep in mind that
such a correction is becoming more likely than at any time since the March rally
started in the next quarter or two.

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The strongest sectors are
Metals and Mining, Natural Resources, and emerging markets in general (China
especially). Market followers who watch trading range breakouts have noticed
the dramatic breakout of several Chinese ADRs in the past two weeks including
SNP (China Petroleum and Chemical), PTR (Petrochina), JCC (Jilin Chemical),
ACH (Aluminum Corp. of China), and CBA (Brilliance China Automotive). Every
single one of these companies has extremely high quarterly earnings growth and
trade at significant discounts to the (Price / Earnings) / Growth ratios of
U.S. stocks. While these stocks are of great value, and may provide for very
lucrative investments as Chinaâ€™s economy continues to boom, investors
must have strong stomachs. These ADRs are thinly traded and can have wild daily
swings and gap moves. We will continue to follow the Chinese market and economy
closely as their economy continues to grow rapidly and therefore continues to
demand an increasing amount of the worldâ€™s commodities including cattle
and food products, oil and energy products, steel and metal products, and precious
metals. For more broad-based exposure to Asia, we like open-ended funds such
as USCOX (US China Region Opportunity Fund) and closed-ended funds such as CHN
(China Fund).

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The main trend continues
to be up for both US and global equities, but things are overdone in most markets
and they are therefore vulnerable to setbacks at any time. Massive fiscal and
monetary stimulus has worked its magic in terms of starting the fire of recovery
â€” now lets see how that fire catches in terms of profit-growth. It still
appears that the most likely dangers that could derail the recovery remain a
global bond route, a dollar crash, a renewed oil crunch and price surge, or
a major terrorist action that breaks the back of consumer confidence.

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Our US long/short model
is doing reasonable well considering the low level of allocation it has had.
We have long encouraged investors to supplement this strategy with or favorite
foreign and global asset plays. 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. 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 portfolios up over 13% ytd by our calculations)
â€” all on worst drawdown of under 7%.

For the week ended Dec.
3, in our Top
RS/EPS New Highs list published on TradingMarkets.com, we had readings of
59, 148, 116, and 73, accompanied by 30 breakouts of 4+ week ranges, with valid
trades in PETD and RADN. For the week ended December 10th, in our Top RS/EPS
New Highs list published on TradingMarkets.com, we had readings of 17, 13, 45,
47, and 18 accompanied by 7 breakouts of 4+ week ranges, with no valid trades
and one close call in JCC. Internal strength has come back SOME, but still remains
slightly suspicious. 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. For the week ended Dec. 3, Bottom
RS/EPS New Lows remained non-existent with readings of 1, 1, 2, and 2, with
no breakdowns of 4+ week ranges, no valid trades and no close calls. For the
week ended Dec. 10, bottom RS/EPS New Lows had readings of 2, 3, 3, 2, and 3,
with no breakdowns of 4+ week ranges, no valid trades and one close call in
ICCI.

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 US 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 change in the new-economy/old-economy theme appeared to be upon us.
We’ve been effectively defensive ever since.

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Mark Boucher

Goodbye Deflation Fears, Hello Inflation Fears

BUY THE FEAR, SELL THE GREED

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