How To Prepare For The Year Of The Mini-Cycle

April 9, 2004
Mark Boucher

As we
have been saying since December, most global markets are now fully
valued.Â Combine that with a peak in global liquidity injection and probable peak
in global growth rates, and you donâ€™t have a nirvana environment for global
equities.Â Yet the cyclical bull market that started in April is likely not dead
yet either. Instead of a broad-based substantial leg higher, investors should
prepare themselves for a volatile set of mini-cycles up and down with a slight
upward bias. The latest correction went merely to the highest levels of a normal
correction and then the bullish employment report sent prices moving higher
again.Â We suspect that further evidence of self-sustaining economic momentum in
the US will be enough to set up a muted leg higher absent global geopolitical
shocks, but investors should temper their expectations for a broad-based
substantial rally from here, while expecting much more volatility.

Global growth will trend toward
more synchronicity in a world economy that is out of balance.
Japan, with the help of Chinese export
demand for Japanese goods, finally appears to have embarked on a self-sustaining
recovery.Â Yet Japan is still dependent upon Chinese demand and the Chinese
economy is overheating.Â Growth is too strong in China and authorities efforts to
slow things down so far have failed.Â Yet Chinese manufacturers are experiencing
a profit squeeze from the surge in commodity prices.Â Chinese authorities are
hoping that the commodity-led profit squeeze and some reserve requirement
increases will be enough to slow its economy in a soft landing.Â Yet if
China has to start tightening severely, this
scenario will prove too optimistic. Watch China closely as it and the US are the
main engines of global growth.Â Australia and the UK are also trying to cool
things.

On the opposite end of the
spectrum is Europe.Â The recovery has been
very feeble in Europe and employment is declining.Â The ECB will likely be forced
to cut rates this summer, and current posturing for such a cut is already
developing.

The profit squeeze in China and
probable slowdown of growth is likely to lead to a correction in the wild runup
in commodity prices that has taken place over the past year. The main trend is
still higher, but supply in certain commodities is building and demand is likely
to ease a bit.

The
dollar is also correcting its waterfall decline of the past two
years.Â Further evidence of employment growth and strong economic numbers from
the US will help provide strength in the dollar, which will likely offset the
massive chronic current account deficits effects for another month or two as the
dollar trading ranges with an upward bias.

Palladium and silver are in
runaway bull moves, but both have resistance levels ahead and have had runups
that will need to be corrected. Palladium has resistance around the 400 level,
while silver has resistance around the 8-10 level.Â These laggards of the
commodity bull move may be the last to correct, but investors long these great
moves should move stops up and become watchful.Â Commodity currencies may be
weak, particularly the overvalued Aussie, if
commodity prices break down with force.

JGBs
are leading a new leg down in global bond prices that will likely be very slow
to emerge.Â US bonds are also among the
weaker ones.Â We like euro bonds/US and
Canadian and euro short rates over British short-rates.Â The prospect of higher
rates is leading to a correction in real estate equities.Â We suspect another leg
up will develop after a realization that rates must rise much faster than they
will this year before real estate will be impacted.

Normally we would expect a
series of mini-cycles up and down with an upward bias into 2005 before economic
pressures are likely to grow to a point where interest rate rise enough to cut
off growth. Inflation pressures are building, and we are at a transition between
reflation and inflation, but these pipeline pressures will take a while to hit
the psyche of global investors.Â

Top global themes include
Russia and Japan (where we would tighten stops), broad Asia, silver and
palladium, lagging resource stocks like papers, coals and chemicals,Â E&P energy
stocks, Shipping, Gaming, Emerging markets and EMs/Developed, Eastern Europe and
Eastern Europe over Europe, foreign markets nominally over US, global small cap
value, Korea, interest rate spreads, and short JGBs. Investors need to be very
flexible and nimble to make good profits this year.

Adding to the uncertainty and
volatility is the huge wildcard of geopolitical instability. The coalition in
Iraq just made a major tactical error by attacking two mosques in Iraq, helping
to brew a more broad-based insurrection than they have yet faced that includes
Shiites and Sunnis.Â Jihadists who had long claimed that the US war was really a
war against Islam will gain political mileage, and the tide could begin to turn
against the already crumbling coalition in Iraq.Â Investors need to once again
watch events closely, as negative news will hit markets in shock-waves.Â Further
terrorist acts could derail consumer sentiment.Â Be aware of the large risk in
these markets.

So far our US long/short model has been relatively inactive during 2004 (only
one official trade – short TRMS), and we continue to suggest investors use some
caution until stocks meeting our criteria expand in breakout breadth. Â 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. 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) â€”
all on worst drawdown of under 7%.Â This did not include our foreign stock
recommendations that had spectacular performance in 2003.Â

This week in our
Top
RS/EPS New Highs list published on TradingMarkets.com, we had readings of
62, 103, 94, 58, and 50, with 46 breakouts of 4+ week ranges, no valid trades
and no close calls. Upside breadth has improved substantially this week.Â
Â Â 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.Â This week, our

Bottom RS/EPS New Lows remained non-existent with readings of 3, 3, 5, 13,
and 3, with no breakdowns of 4+ week ranges, no valid trades and no close
calls.Â The short-side breadth remains bleak and it will be important to watch
for sector rotation and underperformance to find the best shorts.Â Letâ€™s see if
we get further confirmation of self-reinforcing recovery in the US and if that
is enough to propel markets into at least a labored move to new highs.

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.Â

Until next week,

Mark Boucher

How To Prepare For The Year Of The Mini-Cycle

BUY THE FEAR, SELL THE GREED

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