Is a growth scare about to develop?

So far the markets have started discounting a US growth slowdown but are still
focusing on inflation pressures. Risky assets faced an initial wave down as
fears of stagflation escalated in May. US markets in particular have recently
begun to discount inflation pressures abating fairly quickly — as US bonds have
rallied, TIP spreads have eased, and inflation expectations have receded.
However USUALLY if growth is to slow significantly, a GROWTH SCARE will develop,
and during this phase profit concerns tend to overwhelm lower bond yields for a
while as both stocks and yields drop together, particularly in risky and
cyclical sectors.

This is normally the period to BEGIN watching for buying opportunities to
develop as long as growth does not appear to be falling off too swiftly. EM’s,
cyclicals, materials, and small caps tend to under perform until this period
when bond yields and stocks fall together in a growth scare. Right now breadth
has not expanded well on the rally in global markets, and volume has fallen off
during the rally since June, meaning internal market action is confirming the
likelihood that a further period of volatile or weak prices can develop from a
growth scare.

We continue to suspect that a growth scare will indeed materialize, but that it
will create a very good buying opportunity in cyclicals and reflation trades,
and not be a precursor to global recession. We also suspect that markets will be
surprised when a global growth slowdown materializes, and not just a US slowdown
in growth. Until evidence materializes that allows us to discount a
reacceleration in growth, we tend to favor long/short pairings to outright
directional positions in global equities. It may well be more of the same mess
we’ve had since May for awhile longer.

Investors should continue to skeptically let market action be the guide. Strong
rallies in the major averages accompanied by high volume to create a couple more
follow-through days would be the first sign of more upside ahead. The real
excitement may not come until the breadth of Top RS new highs starts to expand
broadly and stocks meeting our runaway up fuel criteria begin to break out with
some plurality. Until then, we still suggest keeping your powder mostly dry. We
still like Large-Cap-Value over small caps and PPH over the market as some of
our favorite plays. Yet we continue to regard this as a TREACHEROUS ENVIRONMENT
where CAPITAL PRESERVATION SHOULD BE PARAMOUNT. Don’t allocate heavily to
anything that doesn’t scream at you.

Unless there are surprising developments in terms of peace initiatives, an even
more expanded ground war phase may be beginning in Israel. The attempted
terrorist attack on ten planes heading from London to the US will not help. The
thwarted al Qaeda terrorist attack on the US makes it appear even clearer that
the vanguard of terrorism has been handed from al Qaeda to Hezbollah, and we
suspect a stronger focus on Iranian-backed terrorism will follow. Investors may
want to watch the rhetoric in editorials in the US and in Israel closely now.
Increasingly there have been calls for attacking Iran and Syria, the suppliers
to Hezbollah, by Israel or the US. A small but growing minority is starting to
believe that if fanatical Islamic terrorism is not dealt a massive blow now,
that it will only lead to global War down the road. There is talk about striking
Iran’s nuclear facilities and even its oil facilities, to knock out the revenue
source that is allowing the constant supply of arms to terrorist Hezbollah.
Investors should monitor if this trend toward calls for broadening the war
substantially grow both here and in Israel. Opinions aside, such action would
have DRAMATIC effect upon global stock and commodity prices. Oil could double
and global recession could follow sharply and swiftly. The odds still remain LOW
of such substantial action — but as talk of it increases the low odds are
rising, and investors need to be prepared if they rise further of the major
risks to capital in the short-run that could entail.

Our US selection methods, our Top RS/EPS New Highs list published on
TradingMarkets.com, had readings of 28, 31, 10, 13 and 18 with 7 breakouts of 4+
week ranges; no valid trades meeting criteria, and no close calls. This week,
our bottom RS/EPS New Lows recorded readings of 24, 10, 17, 29 and 40 with 8
breakdowns of 4+ week ranges, no valid trades and no close calls. The “model”
portfolio of trades meeting criteria has some time back exited all positions and
is 100% in cash.

Sometimes the sidelines are the best place to be. We suspect we’re still in one
of those times. Conflicting forces continue to grow, and high odds sustainable
moves don’t appear likely to materialize just yet. Until they do, we suggest
mostly keeping your powder dry and watching events transpire closely.