Market Internals Look Better than Indexes

April 12, 2002
Mark Boucher

While
a pullback in the major averages continued
this week, the internal market is
barely correcting. Small-cap value
indices made new highs this week or hovered near new highs, as did Latin
Emerging Markets and Eastern European markets. As
long as the internal leadership (small cap and mid cap value segments) of the
U.S. market, along with the leadership of the global rally (EMs) and commodity
markets hold, we doubt the market indices will mount a serious retest of the
September lows. Instead, the indices are
in a trading range while the leadership consolidates and/or drifts higher.
If this continues, the market is likely to eventually move higher.
But investors must prepare themselves for trading ranges and
disappointing action in the main indexes as a likely scenario of overvaluation
and continued overcapacity problems remain a weight on this mini-bull market.

Commodity,
commodity currency, and foreign stock markets continue to confirm the recovery
scenario over the intermediate term. In
the U.S. the evidence continues to mount that the recovery will be faster-than-expected
at first, and then slow down markedly. Keep
looking for an improvement in breadth, such as a 9:1 up/down volume day, the
five-day moving average of advancing volume to be 77% or more of total volume,
an 11-day A/D ratio of 1.9 or more, or a 10-day A/D ratio of 2 or more.
A real bull market should flash these breadth indications â€” but whether
we will get these on this mini-bull move that is unlikely to make new highs in
the major indexes, only time will tell.

We will seek out value domestically in
our U.S. long/short strategy, but the real opportunities can be found overseas.
Globally, the U.S. and other developed markets are NOT
the best places to find value. Most of the value-based opportunities can be
found in Emerging Markets such as Asia (x Japan), Eastern Europe, and in Latin
America. There is value in these areas as
a result of the bear market that plagued Emerging Markets for much of the 1990s.
It is primarily in the small and mid-cap arena across the board that
investors can still find names that offer some value, just as has been the case
in the U.S.

Top
RS/EPS New Highs improved as the week progressed, numbering about 50 for
three straight days. There were a total of 30 breakouts, which is also an
improvement over the last couple weeks. There
were also a couple close calls that almost met all of our criteria, so quality
is improving as well, despite the down drift in the averages.
However, Bottom
RS/EPS New Lows also improved â€” and we must watch to make sure these
donâ€™t rise consistently above 20, which would be a signal of more market
weakness.

Our
overall allocation remains DEFENSIVE, with 76% in
T-bills awaiting new opportunities. Our model portfolio
followed up weekly in this column was up 41% in 1999, up 82% in 2000 and up
16.5% in 2001 â€” all on a worst drawdown of around 12%. Weâ€™re now
up about 6% for the year 2002, which marks a nice gain for the week. While we
expect decent returns from our long/short strategy, there will probably be more
frequent and larger drawdowns than weâ€™ve had so far due to the volatility in
the U.S. market.

For those not
familiar with our long/short strategies, we suggest you review my 10-week
trading course on TradingMarkets.com, as well as in my book The
Hedge Fund Edge, course “The Science of Trading,” and new
video seminar most of all, where I discuss many new techniques. 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 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.

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 (see 10-week
trading course) breaking down
out of a downward flag or down cup-and-handle that is in a leading group to the
downside.

Overall a
plurality of markets is still confirming the global recovery scenario, and the
big picture will remain healthy as long as Emerging Markets and small-cap value
show leadership.

Market Internals Look Better than Indexes

BUY THE FEAR, SELL THE GREED

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