Retest Outcome Getting Critical

June 21, 2002
Mark Boucher

A few weeks ago we noticed that
the decline in US stocks was beginning to feed declines around the world, and we
urged global investors to get heavily in cash. Today,
only Thai stocks and Indonesian stocks are bucking the correction/downwave
trend. We have also been commenting on
the ominous nature of the market if the S&P does break critical support in
the 925-950 region. Global bond markets
are hinting that this is a real possibility with their current strength.

However, most commodity markets
remain flat to slightly strong. As we
discussed last week, tin and nickel
broke out of major basing patterns this week.
These markets are still discounting a global manufacturing recovery down
the road. And while bond yields seem to
be discounting more economic weakness, yield spreads continue flat to narrowing
in the junk to treasury spreads â€” meaning these markets are not yet
discounting a return to recession. This
is true in the U.S. and in Asia.

The bottom line is that some
markets warn of deflation returning (global bonds), while other markets continue
to suggest a manufacturing recovery continuing (base metals and some
economically sensitive commodities). This
means the markets are not yet clear on the outcome of the current retest.
A new bear leg below 925-950 and below the September lows in all the
major US averages remains likely to pull the rest of the world lower and to
threaten the durability of the global manufacturing recovery currently underway.
So the current retest is becoming more and more critical to the outlook
for investments over the coming year and beyond.
Investors need to watch the markets carefully for clues and clear
indications of whether the retest will hold or a new bear leg develops.
So far, not enough markets are tipping their hats to give us a high odds
expectation.

And from a macroeconomic
perspective, it is not yet clear how much damage the dollar decline will do if
it continues either. The dollar is
approaching the critical 110 support area and sentiment is getting overdone on
dollar weakness. So a more prolonged
consolidation or correction may well develop somewhere in this area.
Then the key question becomes what will be the response of foreign
central bankers. If they begin to ease
monetary policy and stimulate in response to the lower dollar, it will have a
relatively benign effect on the global economic picture.
This appears to already be beginning in Asia.
The combination of a much weaker dollar, little policy easing abroad in
response to it, and new lows in the US and global markets would spell a very
difficult period ahead as a new bear wave would be upon us.

So far, our breadth indications
are not yet pointing clearly in either direction either.
Last week it began to look like the bear phase was almost gathering the
type of breadth needed to break a critical support zone.
However, the quality of new lows remained poor. Leadership is starting to show
itself clearly in both directions and trades and close calls are increasing in
both directions. Leadership on the upside
is showing up in Regional small banks, Real Estate and Mortgage companies, HMOs,
Housing, Retail and Food groups. Leadership
on the downside is expanding in Telecom, Semiconductors, software, biotech,
healthcare, utilities, media, and communications groups.
These are the areas to look for stock breakouts meeting our criteria.

Investors should continue to
watch the US and developed markets for some follow-through days on the upside
accompanied by much better breadth. Remember
that our own breadth tools have not flashed buy signals since the early 2000
top. We will therefore be keeping our eye
out 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

One of these will tip us off to
a totally confirmed bull move. But again,
donâ€™t be surprised to see a couple of follow-through days and no further
breadth confirmation, leading to a small, but barely catchable upmove similar to
what we had off of the September lows.

From a psychological and
economic standpoint, the US and developed markets need more evidence of
broad-based earnings gains so that earnings gains can begin to take over
from monetary stimulus as the fuel behind stock price gains.
Our macro analysis along with study of the marketâ€™s reaction to
overvaluation historically tells us that although the market can ALWAYS
DO ANYTHING, we are probably wise to expect only a potential MINI bull
move â€” playable, a la 1965-1982, but
nothing like the bull moves of the 1982-2000 secular bull markets, for many
years to come.

Our US long/short strategy
continues to show reasonable gains with very low risk this year.
Weâ€™re making money at close to a 20% rate so far this year, OK, but not
exactly wonderful. Investors may have to
adjust to a lengthy period of global multiple convergence, where overvalued U.S.
stocks have trouble rallying en masse for many years, while certain sectors
present limited but good opportunities such as weâ€™ve seen in the homebuilding
and regional banking industries this year.

There were only 19 breakouts out of
four-plus-week consolidations on the upside
last week, and 14 breakdowns of four-plus-week consolidations on our new high and new
lows lists. A successful retest without a decent rally may give us opportunities on
both sides of the fence in the environment ahead. However,
continued improvement in new low numbers and quality will help tell us whether
this is a retest of the September lows or whether it is the beginning of a new leg
down in an ongoing bear market. Watch
carefully!

Our official model portfolio
overall allocation remains VERY DEFENSIVE. Weâ€™re now
100% in T-bills (including short sale proceeds) awaiting new
opportunities, and 32% invested in two short and two long (our short proceeds
finance our long trades). Our model portfolio followed up weekly in this
column was up 41% in 1999, up 82% in 2000 and up 16.5% in 2001 â€” all on a
worst drawdown of around 12%. Weâ€™re now up around 7.21% for the year
2002.

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: Mid-Atlantic
Medical
(
MME |
Quote |
Chart |
News |
PowerRating) @38.35 (39.14) w/33 ops and New
Century Financial
(
NCEN |
Quote |
Chart |
News |
PowerRating) (31.95) w/26 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 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 (14.7) w/16.25 ops, and Cable
& Wireless Ads
(
CWP |
Quote |
Chart |
News |
PowerRating) (7.77)
w/a 9.7 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.

Will the US bubble-popping
bear market pull the world back into a deflationary slump? The key will be how the foreign central banks react to further
US stock
and dollar weakness and in whether the US market can hold at critical support. A flurry of sell orders is likely if the September lows are broken in
US and
global markets. So the retest underway will be critical for the global economic and
investment outlook. If the market
can muster up some follow-through days on the upside and breadth can continue to
expand, then the global manufacturing recovery will survive for now and a better
investment environment for EMs and some growth stock plays will develop. Watch the plurality of markets for clues as
to what the next move will be.

Retest Outcome Getting Critical

BUY THE FEAR, SELL THE GREED

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