One Of The Biggest Lessons In Investing

• February 7, 2003
• Mark Boucher

The
situation for the market remains pretty much the same.
Colin Powell gave some persuasive evidence to show that Iraq was clearly
in material breach of the last UN resolution. However,
France, Russia and China still have huge oil contracts with Saddam and they
still want to stall his unseating and avoid war as much as possible.
The UN now risks dying the same way the League of Nations did with the
onset of WWI.

Meanwhile investors
are rightly uncertain enough to stay mostly on the sidelines.
Corporate managers now have much more responsibility for their actions
but higher uncertainty — so potential capital goods purchases and expansion
plans are held back. The risk premium to
equities and probably all investments is very high.

European stocks
continue to test their lows in local terms, global bond prices remain strong in
a flight to safety, gold and foreign currencies are reaching resistance levels
in their runup and oil prices continue to new highs.
Is this a new leg down in an ongoing bear market, 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 continues to suggest that the economy is recovering and holding up well
despite global turbulence. Investors do
need to remember that GDP growth went up nicely during the 1965-82 period, while
the market fell 70% in real terms. But,
rapid money growth, fiscal stimulus, and stronger residential prices argue for a
stronger economy in the absence of a geopolitical shock.
Investors may be over discounting the downside — but they are unlikely
to wake up to this fact until the major geopolitical uncertainties ease up. 

The massive troop
buildup continues and Saddam’s violations of resolutions continue, with little
real hope of his changing enough to stop war. The
war is likely to be a “sell the rumor, buy the news” affair.
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 as the Gulf War because the
outcome of the Iraqi conflict is just a phase of an on-going war on terrorism
that will not come to an end.

If Saddam or al
Qaeda retaliates in any major way, the market could quickly move from euphoria
to shock. 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.

The market broke key
support and could test the October lows although the VIX is getting overdone on
downside sentiment.  Some regional
banks are outperforming, like our
(
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PowerRating). Gold
and foreign currencies are rallying but they
are hostages to Iraq in the short-term (and overdone and with too high sentiment
figures).  Industrial commodity
prices, which appear likely to continue rallying upon either war outcome, are
nonetheless also getting overdone on the upside presently. 

Therefore investors
should keep a mix of cash in various currencies (Everbank.com) and sit on their
hands mostly until the global showdown develops some clarity. 

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
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.

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%.  While
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 84% 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 off 0.19% for the year 2003. And
we’ve emphasized defense as much as making money.

Unbelievably, Top
RS/EPS New Highs have still mustered up just ONE solid week of consistent
+20 or higher readings since the 7/24 lows. This
past week new highs on our lists remained at dismal levels, as did new lows on
our lists. We had readings of 
14,13,14, 8, and 7 new highs on our Top RS/EPS New Highs list accompanied
by just 4 breakouts of 4+ week ranges, with one close call Rollins
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PowerRating), no valid trades, and one stop-out of long: American
Pharmaceuticals
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PowerRating).

Bottom RS/EPS New
lows had readings last week of 19, 25, 14, 20, and 18, accompanied by 13
breakdowns of 4+ week patterns along with a couple close calls on the short
side.  Neither buying pressure nor
selling pressure is strong enough now to really move the market, but investors
need to realize that when buying pressure dries up the market tends to drift
lower.  My guess remains that buying
pressure will not return in force until there is some clarity in the Iraqi
situation. 

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, and 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 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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PowerRating) @40.99 (46.83)- w/ 
43 ops to lock in profits, and WebMD
(
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PowerRating) @9.44 (9.39) w/ an 8.5 ops, and new this week: American
Pharmaceuticals
(
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News |
PowerRating) @25.64-out 22.8 on 
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 (see interactive
training module) 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.

One of the biggest
lessons in investing is knowing when to hold back and wait for better
opportunities to develop. That’s
defense that cuts drawdowns and prepares one to take advantage of the truly
remarkable opportunities that develop at market bottoms for investors with their
capital intact. Now is the time 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.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.  

Mark