Rally Under Way?

• October 5, 2001
• Mark Boucher

Last
week we highlighted the fact that bear market breadth had peaked.
In the last week we have had two follow-through days on the upside in the
S&P, and breadth on our Top RS/EPS new highs list is equal to breadth on our
Bottom RS/EPS new lows list. We also
mentioned last week that most oversold indexes have flashed bottoming signals.
Thus, we may be at the start of a rally. At
this stage we cannot tell for sure if it is a new bull market or just a bear
market rally. Our hunch is that it will
be similar to the March lows of this year — a bear market rally.
But Europe is leading the rally and we’ve had a TON of monetary stimulus.
So let’s again review the breadth indicators we’re watching for two or
more of to turn us more bullish:

           
1) A day when up-volume outnumbers down-volume by at least 9 to 1.

           
2) Five-day up-volume is 77% or higher of the total volume for the last 5
days.

           
3) Either the 10-day A/D is 2 or greater, or the 11-day A/D is 1.9 or
greater.

           
4) The S&P rises by 2.75% and 70% or more issues advance.

           
5) O’Neil’s follow-through days develop on several indexes at a time on a
given day and volume is clearly at a relatively high level in all those indexes.

           
6) Either the 15-day EMA (of advances – declines) reaches +300 or higher,
or the eight-day EMA (of advances – declines) reaches +400 or higher, or the
six-day EMA (of advances – declines) reaches +500 or higher.

Investors
should also realize that there is one thing more important than the breadth
indications above. And that is
leadership. IF we start getting lots of
valid breakouts of four-plus-week consolidations (flags or cup-and-handles) of
up-fuel stocks that are making our Top RS/EPS New Highs list in leading groups,
THEN we will be steadily increasing our allocation to the long side — whether
breadth signals a typically strong bull market or not.
Let’s watch carefully and see what the market will give us.

In
the meantime, we continue to suspect that a sustained rally is unlikely until
economic growth is more assured and the uncertainty over the response to the
attack is clearer. So far, we have
neither the breadth indications nor leadership indications that a sustained
uptrend is in the making. But the market
has reached historically oversold levels and a bounce lasting weeks to months is
likely. Remember that with this much
uncertainty in the market, sentiment can change from bullish to bearish on a
dime — or on any shift in news. Let’s
hope the downed plane of Israeli’s in Russia was not another terrorist attack!

Unfortunately,
economically sensitive commodities remain clearly and universally bearish.
Copper, cotton and lumber all made new lows, while bonds made new highs.
Commodities are discounting recession with no recovery yet in sight.
We suspect a sustainable rally in stocks will not develop until we
get clear bottom formations and upside breakouts in copper, lumber and cotton,
and U.S. bonds begin to top out and break down. Right
now these markets are continuing to discount further economic weakness.

Let’s
look at the breadth numbers on our lists for the week.
Top
RS/EPS New Highs vs.
Bottom RS/EPS New Lows for the latest week were 10/97, 20/15, 14/29, 17/31
and 32/30. New lows’ dominance has
disappeared, although this breadth is trading-range indicative — with no clear
dominance by shorts or longs, and neither showing 20 or higher consistently on
the week. Breakouts vs. breakdowns of
four-plus-week consolidations on our lists shifted from new lows outshadowing to
new highs outshadowing, with readings of 3/4, 5/0, 3/2, 1/0 and 6/0.
We had a close call on the upside and a buy trade, while we took nice
profits on
(
GX |
Quote |
Chart |
News |
PowerRating) below 2 on the short side, and we also took profits on short
BRP via trailing stops on the short side. So
the action has shifted dramatically toward the bulls side, at least temporarily
— but neither side is yet showing the dominance required by a clearly catchable
trending move. Remember, though, that
breakouts of valid four-plus-week patterns take time and generally only begin a
few weeks after a significant bottom. But
buying the leaders on breakouts allows you to more than catch up for market
moves since the bottom missed by waiting. So
let’s see if this rally has teeth or not by whether it sets up leadership
breaking out of valid patterns with fuel or not.

Our
overall allocation is now DEFENSIVE with
84% in T-bills awaiting new opportunities.
Our
model portfolio followed up weekly in this column ended 2000 with
about an 82% gain on a 12% maximum drawdown, following a
gain of around 41% the prior year.
For year 2001, we are now up about 14.5%, with a heavy cash
position.  

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 an environment unclear directionally, we also only buy or short stocks on
leading or lagging industries according to our group and sub-group new high and
new 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.

Upside
breakouts meeting upfuel criteria (and still open positions) so far this year
are: American Home Mortgage Holdings
(
AHMH |
Quote |
Chart |
News |
PowerRating)
@20 w/16 ops. Continue
to watch our NH list and buy flags or cup-and-handle breakouts in NH’s meeting
our up-fuel criteria — but continue to add just two per week and only in
leading groups. If we get two
or more of the above breadth criteria for the overall market developing from
here on, we’ll then drop the “two per week only” advice on longs — but until that
develops, let’s remain somewhat cautious.
 

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: Global Crossing
(
GX |
Quote |
Chart |
News |
PowerRating) @6.05 — took profits at 2; Phelps Dodge
(
PD |
Quote |
Chart |
News |
PowerRating) @38.1 (26.56) — now use 30.5 ops; Brasil Telecom
(
BRP |
Quote |
Chart |
News |
PowerRating)
@31.69 — out on 26.5 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 it in a leading group. The oversold nature of the market leads
us to suggest that investors remain cautious by only adding two shorts in a week.
 

We
still suspect that either new lows or a retest of recent lows will develop over
the next 10-20 weeks until solid evidence of recovery begins to emerge. But let’s let the market show us with breadth and then leadership
measures if a really playable rally can materialize off of this fall’s lows. Until we get a couple breadth indications or handfuls of valid breakouts
of four-plus-week consolidations of up-fuel stocks daily, the benefit of the doubt belongs
to the bears and to being cautious. Let’s
be patient and watch what happens with the recession and new War on Terrorism,
while paying super close attention to clear market reactions to events and to
internal market dynamics.