Ready For Yet Another Trading Range Environment?

• July 19, 2002
• Mark Boucher

The S&P along with many major
averages has now broken down below critical support.
It’s a real bear market, folks — and we’re probably just starting
the longest stage, the second stage of a bear market, where investors begin to
come to the realization that all is not well and that a return to the old
environment of the great preceding bull market is unlikely.
The final stage is capitulation, when everyone throws in the towel and
swears off equities for good — that’s likely years away, and a few mini bull
and mini bear markets down the road.

Right now the market is oversold.
The VIX and other oscillators are pointing to the potential for a rally
upon any catalyst. And sentiment
indicators are down at levels normally associated with rallies setting in.
Remember that none of these indicators will work the same way in a major
bear market as they have worked in the secular bull market.
The S&P futures DID bounce off of a Fib level on a Fib date this
week, so it is possible that last week’s lows will hold a while.
Certainly some time this summer we are likely to get at least a little
bounce off of these extreme levels. Breadth
seems to be indicating that a return to a trading range environment is possible
some time soon. But with the strong
breakdowns of this past two weeks, investors should not expect a new bull market
any time soon. 

The one silver lining is that so far neither global bonds
nor commodities nor economic variables are showing that the new lows are
dragging the world back into recession. Investors
need to keep a keen eye on these markets for such signs.
Watch the CRB and Goldman
Sachs Commodity Index, along with base
metals, cotton, and lumber
for a plurality of these markets clearly breaking down for a retest of lows
before interpreting the possibility of a return to global recession.
So far, the manufacturing recovery, particularly in Asia, is on without a
hit from developed stock market woes.

Breadth indications over the latest week showed some
downside dominance, but not clear strength on either side of the aisle.
Continue to wait 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, and a couple of good O’Neil
Follow-Through Days to make for a totally confirmed bull move.
But again, don’t be surprised to see a couple of follow-through days
and no further breadth confirmation leading to a small, but barely catchable, up-move
similar to what we had off of the September lows on any potential rally.   

Our US long/short strategy has gotten whipsawed quite a bit
over the last few weeks and is currently in a drawdown of nearly 5%.
We now have one short position with a stop to lock in profits left.
Investors may have to adjust to a lengthy period of global multiple
convergence, where overvalued US 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 on
the upside, and tech, telecom and utilities on the downside.
The Dow Utilities completed a major monthly head-and-shoulders top ahead
of most of the averages over the last month, and this sector looks poised to
continue to underperform. 

Top
RS/EPS New Highs this past week weakened further to pathetic readings of 3,
2, 5, 6 and 2, with no really close-call potential trades.
Wait now for at least a couple of follow-through days before anticipating
that this retest is over, and look for solid leadership in the breakouts before
thinking about getting aggressive on the long side.
Bottom
RS/EPS New Lows rose back to consistently over 20 last week with readings of
119, 34, 89, 34 and 41. A move to under
20 by new lows on our lists will probably announce the potential for an easing
of bearish pressure. The quality of new
lows is still not very strong with only eight breakdowns of four-plus-week
consolidations and just one close call. Watch
the new low numbers for clues on when selling pressure is clearly subsiding and
the new high numbers for clues as to when buying pressure is actually showing
up. So far, no good on either front. 
But with this degree of oversold and sentiment, a rally could be sharp
and happen from anywhere — making shorts a bit dangerous, in addition to
annihilating potential long trades. 

Our official model portfolio overall allocation remains
ULTRA DEFENSIVE. We’re now 100% in
T-bills (including short sale proceeds) awaiting new opportunities, and 8%
invested in one lone short position. 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 4.83% for the
year 2002. Let’s wait for a bit
better environment before positioning heavily.

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.

Upside breakouts meeting up-fuel criteria (and still open
positions) so far this year are: New Century Financial
(
NCEN |
Quote |
Chart |
News |
PowerRating) @31.95 — out on 26 ops;  No
other long positions right now. 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 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 (10.75) w/13.1 ops;
Computer Network Technology
(
CMNT |
Quote |
Chart |
News |
PowerRating) @6.63 — out on 6.6 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.

The key question now is whether the bear market in
developed-country stocks will carry the global economy into recession with it or
not. This may take some time to resolve.
Right now commodities and bonds are not saying “yes” to renewed
recession. 
If the world can muddle through the next couple quarters with growth
intact while stocks continue to correct (with bear rally intermissions) then a
real doomsday scenario can be averted (though stocks won’t be wonderful
investments for some time). 
Property and other markets that have so far held up would be heavily
affected by this, as stocks have been so far. 
The Fed and central bankers will fight this doomsday scenario tooth and
nail.  Whether they can prevent it
or even delay it, remains to be seen.  It
will certainly be exciting times for financial markets in the months and years
ahead.