Nail-Biting Time On Retest

• June 28, 2002
• Mark Boucher

The
dollar crash is feeding globally and bringing world equities down
with it. A dollar decline that is
accompanied by foreign central bank easing is a net stimulus to the US economy
and will have little negative effect globally. However,
a sharp dollar decline that is unaccompanied by foreign central bank easing will
act like a competitive devaluation and be deflationary for the global economy
and have only muted stimulative effect on US manufacturers, because it will be
offset by declining demand for US products abroad.  

So far, some Asian central banks are catching on and
are starting to ease. Japan is easing slightly in the form of currency intervention.But the ECB seems transfixed on old inflation data and is talking about
tightening, not easing. The world
index, along with the major US indexes, are now getting dangerously close to the
September lows. If these lows are
broken, we suspect -a ot of investors will throw in the towel on this market and
a flood of sell orders will ensue.  

Therefore,
investors need to stay cautious and watch this retest carefully. New lows and significant further downside action in
US and global
indices beyond the September lows will stall the current economic recovery and spill
over to even the stronger markets abroad. The
breadth of new lows vs. new highs is also starting to indicate that a
downwave can go further. Watch the
breadth of new highs and new lows carefully and do not enter any longs
aggressively until we’ve had some good follow through days on the upside and,
preferably, more breadth thrust indications. A critical region is the 925-950 support level in the cash S&P
500
(
$SPX |
Quote |
Chart |
News |
PowerRating). If this level gives way, then the economic environment will clearly
change for the worse. Right now,
only Thai stocks and Indonesian stocks are bucking the correction/downwave
trend. 

We try to look at
the broad-brush message of all markets to give us a clue of how reliable a trend
is. Global bond markets are hinting
that new lows in stocks is possible, but not yet strong enough to give clear
indication. NOT discounting a return of deflationary pressure. Base metals
Tin and Nickel broke out of major basing patterns recently
and continue to show strength. These
markets appear to still be discounting a continuation of the global
manufacturing recovery ahead. 

Likewise,
yield spreads have re-widened some, but are not nearly at the levels associated
with the September lows yet on a broad basis.This
is true in the US. and in Asia. The
bottom-line is that some markets warn of deflation returning (global bonds),
while other markets continue to suggest a manufacturing recovery continuing
(base metals and some economically sensitive commodities). This means the markets are not yet clear on the outcome of the current
retest. It also means that
investors are advised to remain heavily sidelined in global equities until a
clearer indication of coming trends materializes.
Investors need to watch the markets carefully for clues and clear
indications of whether the retest will hold or a new bear leg develops. So far, not enough markets are tipping their hats to give us a high odds
expectation.

Breadth indications
are now BEGINNING to point toward the possibility of further downside action,
but have only done so for a day. A
week of new lows over 100 and new highs under 20 would render a much clearer
picture. Yet the quality of new
lows remains less than optimal for the bears. This week, new highs remained  fairly
strong until yesterday. Leadership
is starting to develop more clearly on the short side, but we need quality
breakouts in more abundance as well. Only
the regional banks continue to clearly buck the downtrend.
Leadership on the downside is expanding in Telecoms, Semiconductors,
software, biotech, healthcare, utilities, media, and communications groups.
These are the areas to look for stock breakouts meeting our criteria. 

Investors should
continue to watch the US and developed markets for some follow-through days on
the upside, accompanied by much better breadth. Remember that our own breadth tools have not flashed buy signals since
the early 2000 top. We will
therefore be keeping our eye out for a 9:1 up/down volume day, the 5-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 to make for a totally
confirmed bull move. But again,
don’t be surprised to see a couple follow-through days and no further breadth
confirmation, leading to a small but barely catchable upmove, similar to what we
had off of the September lows. 

From a
psychological
and economic standpoint, the US and developed markets need more evidence of broad-based earnings gains, so that earnings gains can begin to take over
from monetary stimulus as the fuel behind stock price gains. Our macro analysis, along with study of the market’s reaction to
overvaluation historically tells us that although the market can ALWAYS DO
ANYTHING, we are probably wise to expect only a potential MINI bull move —
playable, á
là 1965-1982,  but
nothing like the bull moves of the 1982-2000 secular bull markets, for many
years to come.

Our US long/short
strategy continues to show reasonable gains with very low risk this year. We’re making money at a
15-20% annual rate so far this year, OK, but not exactly wonderful.
Investors may have to adjust to a lengthy period of global multiple
convergence, where overvalued U.S. stocks have trouble rallying en masse for
many years, while certain sectors present limited but good opportunities such as
we’ve seen in the homebuilding and regional banking industries this year. 

Top
RS/EPS New Highs this past
week weakened with readings of 29, 33, 28, 31, and 12. We did have several close
calls on the upside and a long trade in Quaker City
Bancorp
(
QCBC |
Quote |
Chart |
News |
PowerRating), despite the decline in breadth. But now we clearly need more quality leadership for any rally to take
hold, along with broader participation before getting more aggressive on the
long side. Wait for at least a
couple follow-through days before anticipating that this retest is over. 

Bottom
RS/EPS New Lows exploded this week with readings of 
58, 78, 79, 56, and 124. This
was the first week with consistently over 50 lows in many months. However surprisingly, the quality of new lows was not very good.
There were 16 breakouts and only 17 breakdowns on the week. We did have a few close calls and a short trade in
Computer Network Technology
(
CMNT |
Quote |
Chart |
News |
PowerRating), but we did not
have tons of potential short opportunities as one would expect with a really
broad market decline that was the beginning of a new leg down. Watch carefully!

Our official model
portfolio overall allocation remains VERY DEFENSIVE. 
We’re now 100% in T-bills (including short sale proceeds) awaiting new
opportunities, and 40% invested in three short and two long (our short proceeds
finance our long trades) trades. Our model portfolio followed up weekly in
this column was up 41% in 1999, up 82% in 2000 and up 16.5% in 2001 — all on a
worst drawdown of around 12%. We’re now up around 7.35% for the year
2002.   

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 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: Mid
Atlantic Medical Services 
(
MME |
Quote |
Chart |
News |
PowerRating) @38.35-out on 33 ops; long
New Century Financial Corp
(
NCEN |
Quote |
Chart |
News |
PowerRating) @31.95 (33.1 ) w/ 26
ops; and long Quaker
City Bancorp
(
QCBC |
Quote |
Chart |
News |
PowerRating) @40 (40)
w/ a 37.75 ops. We’re now as
loaded as we can get with regional banking type plays until we can move our
stops up.  Continue to watch our NH
list and buy flags or cup-and-handle breakouts in NHs 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 the market environment improves.

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 ILEX Oncology 
(
ILXO |
Quote |
Chart |
News |
PowerRating) @13.76 (14) w/ 16.25 ops;, and
Cable and Wireless Plc
(
CWP |
Quote |
Chart |
News |
PowerRating) @7.77
(7.7) w/ a 9.7 ops; and short Computer Network
Technology
(
CMNT |
Quote |
Chart |
News |
PowerRating) @6.63 w/ an 8.6 ops. 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 but only add up to two
in any week (and only in the weakest groups) until market weakness is more
pronounced.
 

Will the US
bubble-popping bear market pull the world back into a deflationary slump? The
market’s actions over the next few weeks will be key.
If the market can muster up some follow-through days on the upside and
breadth can continue to expand, then the global manufacturing recovery will
survive for now and a better investment environment for EMs and some growth
stock plays will develop. If the
broad markets all make new lows on strong volume and weakness continues, it will
be a much broader bear market than we’ve seen in decades.
Watch the plurality of markets for clues as what the next
move will be.