Playable Rally Is Underway–Here’s How To Trade It

• October 8, 2004
• Mark Boucher

Global
Equity Rally Leaders EM’s and Resources

The current soft-landing is economically bullish for equities.  It means that
the global recovery has legs, yet it won’t grow so strongly to ignite
inflationary pressures for some time.  The soft-landing is global and centered
in the US and China.  Global bonds have rallied sharply as the deceleration took
hold — this relieves the market of interest rate pressure.  It is likely that
even the obstinate Fed will eventually slow the pace of rate-hikes in response
to slower growth.  A prolonged period of negative interest rates in the US is
likely to continue to be necessary to stabilize the global economy, and this is
bullish equity markets.   

Normally the US dollar would
fall sharply in response to the US’s rising current account surplus, and rates
would move higher as inflationary pressures increased.  However the Asia-US
dynamic is not letting this occur.  Instead, Asia uses its excess savings to buy
US bonds, thereby keeping the dollar strong compared to Asian currencies, and
keeping US interest rates low.  As the dollar weakens versus other currencies,
Asia lowers its own interest rates to keep their economies running at a strong
pace.  This cycle is artificial but it will likely continue until one of three
things stops the dynamic.  A global shock that changes consumer sentiment
sharply could unwind the Asian-US circle.  Eventually in absence of a shock
either the Asian economies will produce so much internal inflation that they
will allow their currencies to revalue in order to quell inflationary pressure,
or the drain on the US growth rate from the current account deficit will slow
growth so much the consumption drops.  Eventually the world will have to deal
with excess capacity and unsustainable levels of consumption.  But in the
meantime the short-term is being bought at the expense of tomorrow.

Thus resource-oriented
countries and EM’s lead the global equity rally.   We continue to like
materials, metals, steels, rails, EM’s (particularly Latin America), Russia,
South Africa, Belgium, Australia, mid-cap value.

Investors can and should play a
diversified group of these leading groups both outright and versus US and global
indexes — but with more caution than would normally be the case for what
broad-based signals.  The FBI is on full alert until the elections in the US. 
There are over 10 global elections in the next month and a half, and this is
prime-time for terrorists to attempt something that could lead to an overnight
shock of unknown proportions.  Avoid too much net long exposure and mix relative
plays versus spiders and global ETF’s with outrights to cut this potential
risk.  Yet investors should realize that IF we can get through the next month
and a half without a major terrorist act and breadth continues strong — the
likely final bull leg of the bull market that began in Oct 2002 will likely be
on roll into the first or second quarter of 2005.

Commodities have heated up
again and not just in the oil patch — the CRB is testing its highs as well, and
copper and lead are breaking out.  Global and US bonds look close to a peak
level. 

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) — all on worst drawdown of under 7%.   This did not include
our foreign stock recommendations that had spectacular performance in 2003. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 106, 162, 238, 141, and 163 with 74 breakouts of 4+ week ranges,
valid trades in VIP and USAP and close calls in CLDN, OCAS, FHRX, and NCS. 
Breadth is expanding again and more close calls would be a call to add some long
exposure.  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.  This week, our bottom RS/EPS New Lows recorded readings of
4, 2, 3, 3, and 4 with 4 breakdowns of 4+ week ranges, no valid trades and no
close calls.  We’re still not getting a lot of trading signals in valid
breakouts, though the environment is improving slightly on the long side — let’s
see if this holds up now that some resistance levels are close at hand.

 

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.

We continue to believe that a playable rally is underway, but that it entails
significant shock-risk.  The rally is catchable for traders who know how to mix
outright longs with relative value plays that feature the strongest sectors over
the market as a whole or weaker sectors.  We suggest less than normal
allocation, however.  The good news is the trading range environment is ending. 

Mark Boucher