Remember This About The Fed

• May 14, 2004
• Mark Boucher

Keep Allocations to a Minimum

Visibility has become very opaque in the markets during the past weeks and will
continue as long as there is disagreement on Wall Street on both the success and
steps the Federal Reserve will take while maintaining growth and simultaneously
curbing inflation.  As recent as a month ago, economists were predicting that
current Fed funds rates would be maintained at 1.0% for the remainder of 2004,
and slowly raised thereafter.  Now, many are expecting four ¼ point hikes by the
end of the year.  In such uncertain times when the market is having difficulty
differentiating between economic growth and inflation, we recommend that trend
followers keep tight stops on current positions and wait for more certain
intermediate term trends to be established before taking new positions.   

Fixed income investments have been massacred during the last month and should
consolidate for a while here.  Keep in mind that the secular trend is bearish
for bonds, and it is best to keep fixed income investments as short in duration
as possible.  Rising borrowing costs brings reminders of the high debt and low
savings rates that characterize the average American consumer and how each
incremental rate hike will effect these consumers.  One must remember that the
Fed is a passionate dictator that will only raise rates gradually and will avoid
stifling growth in the US economy at all costs.  The Fed has spent the past two
years fighting deflation with the most accommodative lending policy in two
generations, so they will not raise interest rates in such a manner as to stop
economic expansion.  One positive factor that the market has not enjoyed since
2000 and must now be factored in is rising employment which will buoy consumer
spending at the same time that borrowing costs weigh down consumer spending. 
Rising employment must also replace the positive effects that house refinancings
and tax cuts had on the market during the past years.  While the tight rope is
this tight, we will wait for the market to take a more concerted direction
before allocating more heavily to equities.

^next^

Although we remain extremely cautious during this
time period with equity allocations, we do like spread trades with the strongest
non-cyclical groups over the weakest cyclical groups.  In particular, we like
Healthcare over Consumer Cyclicals.  We expect healthcare profits to continue to
rise independently of the market, and although consumer cyclicals might make an
oversold rally against this spread in the short-term, we expect them to
underperform relative to Healthcare over the intermediate and long-term.  The
strongest equities are in groups that have the ability to pass inflationary
pressures onto consumers, including the Energy, Healthcare, Technology Security
and Food related sectors.  The weakest groups are Banks, Semiconductors,
Precious Metals, Airlines and Autos.  Interest rates are weighing on Banks and
Autos, overvaluation is putting pressure on Semiconductors, the strengthening
dollar is suppressing Precious Metals, and high energy prices are the culprit
for falling airline profits. 

 

So far our US long/short model
has been relatively inactive during 2004, and we continue to suggest investors
use some caution until stocks meeting our criteria expand in breakout breadth.
 Investors should continue to cautiously add stock exposure as trade signals are
generated that meet our strict criteria, as well as allocate to our favorite
segments on breakouts and signals as advised above.  With our model
portfolio having been essentially in cash since November, it has been
frustrating for many — but market environments like March and April make this
position seem wise.  These are tough markets and traders must be nimble and
willing to wait for good odds to risk capital.

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 7, 14, 4, 8, and 6 with 3 breakouts of 4+ week ranges, no valid
trades and no close calls.  Upside breadth has deteriorated to neutral during
the past two weeks.  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 rose from the
depths, registering readings of 23, 56, 97, 15, and 23 with 19 breakdowns of 4+
week ranges, no valid trades and no close calls — breadth on the short-side has
improved remarkably in the past weeks, and we are eagerly looking for stocks
that meet our downside criteria. 

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 advise keeping allocations low until the trend is more certain. 
Remember that in the markets it is better to sit on the sidelines than it is to
play and lose

Mark Boucher