How To Play The Dominant Theme

Investors’ anxiety and fear over the outcome of the likely invasion of Iraq by
the US are now a dominant theme impacting investments.
The US equity
rally stalled at the 200-day MA resistance levels, European stocks are testing
their lows in local terms, global bond prices are rallying in a flight to
safety, gold and foreign currencies are moving higher, and oil prices are
spiking up. Is this a resumption of the bear market in equities or a temporary
setback that will come back after a resolution in Iraq? Will the Middle East
crisis spin out of control and lead to a return of global recession following
soaring energy prices, or will a quick resolution be the key to turning
investors sentiment higher? When will the US invade?

Recent US economic data suggest
that last year’s economic weakness is ending. Rapid money growth, fiscal
stimulus, and stronger residential prices argue for a stronger economy in the
absence of a geopolitical shock, yet investors are too aware of major
geopolitical uncertainties and risks to care.

Therefore, pressure on the Bush
administration to end the uncertainty and take some clear form of action is
building to a pressure point. Yet Bush faces difficulty, in that international
opinion against a US invasion is building, while domestic support for a US
military action is dwindling. Troop movements suggest that the decision to
attack has already been made. However, unlike in the Gulf War, market
positive reaction may not be immediate once invasion begins. This time it may
well take clear signs that the US has prevailed without major damage before
demand returns
. And any positive effects may not be as long-lasting because
the outcome of the Iraqi conflict is just a phase of an ongoing war on terrorism
that will not come to an end.

If Saddam or al Qaeda retaliate
in any major way, the market could quickly move from euphoria to shock. Oil
could explode on a retaliation, or plummet on clear US victory. Gold and the
dollar could drop further on invasion and any negative news, while the opposite
would occur on an apparent quick resolution. The bottom-line, therefore, is high
volatility and risk that no one can accurately anticipate the outcome of with
any kind of reliability.

Investors should realize too
that many of the supposed opponents to invasion are simply protecting their
interests. Since the UN inspectors were sent home by Iraq in the late 1990s,
France, Russia, China and Germany have signed 90% of the deals with Saddam
representing over 50 billion barrels of oil and over 20 billion in net
profits. These deals will fall apart on an invasion, as Bush’s plans are to use
the revenues on behalf of the Iraqi people. Let’s just say that French, Russian,
Chinese and German monetary interests happen to coincidentally be clearly
aligned with their “humanitarian” position to wait as long as possible and avoid
ousting Saddam.

The market broke key support
and could test the October lows, although the VIX is already getting overdone on
downside sentiment. Some regional banks are outperforming. Gold is making new
highs while the dollar plummets to new lows (though it is approaching support
from the 1999 lows versus the Euro and SF soon). Resources and industrial
commodities remain a dominant theme likely to do well in 2003. Commodity
currencies are also taking off versus the dollar. A feeble global economic
recovery is underway, but psychologically it will be difficult for investors to
sink their teeth into it with huge risks abounding and the pain of the last
three years clear in mind.

Equity investors may be well
advised to diversify some into foreign currencies, base and precious metals, and
particularly commodity funds and indexes like the CRB with a portion of capital,
as reflation is emerging as a dominant theme. Broad commodity indexes with a
smaller allocation to oil, like the CRB, are likely to be one of the better bets
for double-digit gains in 2003, though they could take a big correction hit upon
a successful invasion result.

However, we also expect a more
decent performance year out of our strategy this year. Once war jitters recede
and the outlook is less risk-prone, we believe the market can launch a strong
move that will give us some catchable long opportunities before returning to the
secular downtrend. But we still need to watch and wait for volume, breadth,
leadership and follow through to emerge
before we can allocate enough to
make much money. Caution is still advised. It is frustrating to be so long and
so heavily on the sidelines, but that’s better than getting chewed up in the
markets in a not-very-positive market environment. It’s better to have
indicators that tell when the environment isn’t very good.

Since March 2000, the world index is down over 45%, the
S&P over 48%, the IBD mutual fund index is down over 62%, and the Nasdaq has
crashed over 76%. Meanwhile, since March 2000, the long/short strategy we
summarize and follow-up each week in this column has made more than 39% on a
worst drawdown of under 6%.
this performance is certainly underperforming our long-term growth rate, and it
is hardly thrilling to have been so heavily in cash since March of 2000, we have
managed to eke out gains with very low risk in a very dangerous market
environment where 9 out of 10 traders have been big losers.

Our official model portfolio
overall allocation remains VERY DEFENSIVE. We’re now 75% in T-bills awaiting new
opportunities, with one sole long position. Our model portfolio followed up
weekly in this column was up 41% in 1999, up 82% in 2000, up 16.5% in 2001, and
up 7.58% in 2002, an average annual gain of over 36% — all on a worst drawdown
of around 12%.
We’re now up 1% for the year 2003. And we’ve
emphasized defense as much as making money.


Top RS/EPS New Highs
have still mustered up just ONE solid week of
consistent +20 or higher readings since the 7/24 lows. And this past week, new
highs on our lists continued to drop. The upward bias has been removed. We had
readings of 9, 14, 5, 6 and 14 new highs on our Top RS/EPS New Highs list with
three close calls and one valid trade in
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. Bottom RS/EPS New lows
have expanded with readings of 16, 23, 37, 18 and 19, but remain below 20
consistently, accompanied by 9 breakdowns and a close call this week. So we
remain heavily on the sidelines yet hopeful — and my guess remains that this
will continue to be the case until there is some clarity in the Iraqi

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 an

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
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 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
up-fuel criteria (and still open positions) so far this year are:
Port Financial

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@40.99 (46.97) w/43
ops to lock in profits and Webmed
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@9.44 (9.49) w/8 ops, and new this week
American Pharmaceutical Partners

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@25.64 (26.6) w/23
ops. Continue to watch our NH list and buy flags or cup-and-handle breakouts in
NH’s meeting our up-fuel criteria — but be sure to only add names that are in
leading groups, and now only add two trades per week once again until leadership
and follow-through improve.

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 breaking down
out of a downward flag or down cup-and-handle that is in a leading group to the
downside but only add up to two in any week (and only in the weakest groups)
until we get better breadth numbers on the downside and better leadership.

The dollar has signaled a major
bear market, and we have suggested for some time that investors participate in
it. However, within this secular downtrend, the dollar downside is getting
overdone. The dollar decline is being exacerbated by negative geopolitical
factors. Nonetheless, sentiment is down at levels normally associated with a
strong rally, the currency is more oversold than at any time in the last ten
years, the dollar’s position via our short-term models suggests that further
declines will not be sustainable, speculators’ positions are at levels
consistent with previous troughs, and most major currencies are approaching key
1999 resistance levels with the dollar approaching significant support.

Yet the dollar could spike
lower if negative news develops on the geopolitical front. We suggest those
short the dollar take partial profits here and raise trailing stops. We suspect
a significant dollar rebound will develop once the Iraqi situation clears up,
which would provide us the opportunity to re-establish short positions later
this year. Remember to tread lightly in any avenue, as there are almost no
investments that a surprise Iraq development won’t effect. At some point later
this year, we suspect we will get stronger evidence of clear new group
leadership on the upside or downside, substantially more breakouts or breakdowns
of close-calls or stocks meeting our criteria long or short, better and more
consistent follow-through by those close calls and criteria stocks that do
breakout or breakdown, and substantially more breadth of new highs or new lows
and breakouts or breakdowns on our list. Watch and wait for opportunities to
improve. Don’t forget that profits can come VERY QUICKLY when things all line
up correctly — like the nearly 50% gain we took from the late ’99-early 2000
three months. But patience is required to not give our big gains back in a less
than optimal period.