Still Need More Evidence Of Sustainable Rally

Non-equity market messages are
hardly encouraging either. Global bond
prices have now breached last year’s highs, discounting poorer economic
conditions. Corporate yield spreads have
come down slightly, but still remain at levels that are discounting a near
depression (in fact, yield spreads are so high now and value so prevalent in
corporate bonds that should a recovery develop, these may make a better holding
than stocks, as they did from 1991 to 1995). Asian
markets, which usually lead in a global economic recovery, have moved up only
grudgingly since July lows. And commodity
prices have not recovered consistently as we would expect in a global recovery,
despite oil prices rallying due not to stronger demand, but in response to low
inventories and war talk. 

Thus, the combination of
tentative market signals, poor clarity in non-equity market signals, and poor
leadership lead us to remain very cautious with respect to both the long and the
short side of the US equity market. If
leadership and broader breakout participation can develop, then this rally may
develop into something nicer than investors have seen for nearly two years.
If leadership doesn’t develop, we may get another leg down before a
catchable rally is upon us.

The potential for Bush’s
invasion of Iraq between Sept. 9 and the end of October (if the election comes
before an invasion, then it will likely be next year, with better weather before
we strike) also leads us to be cautious. War
is a volatile and fluid situation that can fake out investors numerous times,
and it warrants more than usual caution if it does develop.
A strike will need to successfully isolate Saddam within two-three weeks
to push markets ahead, if it does develop.

Therefore we suggest investors
wait and watch for more indications of better breadth on a large number of
fronts. Look for more strong rally days
on ABOVE-average volume. Watch for
another breadth thrust up, like another 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.
See if the market can continue to rally on negative news.
See if foreign markets start to show better signs of participating in a
rally. See if commodity prices (besides
oils and grains) can show broad-based strength. See
if bond prices retreat in response to better economic expectations.
Watch for clearer signs of further concerted global monetary stimulus and
a Fed rate cut. And most importantly,
wait for a much larger number of new highs on our lists and breakouts of valid
four-plus-week consolidations in stocks that at least almost meet our criteria,
before thinking of allocating aggressively to this market. 

Until we get substantially
better evidence of a potential rally, our strategy remains ultra defensive, but
continues to slug out small gains. Since
March 2000 the world index is down over 45%, the S&P over 48%, the IBD
mutual fund index is down over 62%, and the Nasdaq has crashed over 76%.
Meanwhile since March 2000, the long/short strategy we summarize and
follow-up each week in this column has made more than 38% on a worst drawdown of
under 6%. While this
performance is certainly underperforming our long-term growth rate, and it is
hardly thrilling to have been so heavily in cash since March of 2000, we have
managed to eke out gains with very low risk in a very dangerous market
environment where nine out of 10 traders have been big losers.
We will hope and watch for a better environment, but wait patiently until
it arrives before risking significant capital. 

Even an excellent poker player
occasionally finds himself in the situation where he gets very poor cards for a
prolonged period, and even his potential bluffing situations face a better show
of cards by opponents. In this situation,
he must sit tight and wait for better cards and better opportunities and let his
ante go repeatedly. But the excellent
poker player knows that eventually he will get better cards and better
opportunities, and when that happens, he will know how to pounce on those better
odds situations. The same must be true
for the top market trader. He needs to
know when the odds are not good and not put his money on the table until good
odds situations develop. So let’s wait
for a better environment and collect our minute interest while we wait. 

Top
RS/EPS New Highs still have not mustered
one solid week of consistent +20 or higher readings, which is disappointing.
Readings this week were 11, 9, 3 and 3, with an astonishingly pathetic
one breakout of a four-plus-week consolidation pattern.
Bottom
RS/EPS New Lows remain at less than 20 consistently, but strengthened quite
a bit with readings of 24, 15, 49 and 47, accompanied by 14 breakdowns of
four-plus-week consolidations, and one valid short-sale.
Remain heavily on the sidelines until the environment improves and
opportunity breakouts of close-calls become more abundant. 

Our official model portfolio
overall allocation remains EXTREMELY DEFENSIVE. We’re
now 92% in T-bills awaiting new opportunities. 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 5.37%
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: NONE.
Continue to watch our NH list and buy flags or cup-and-handle breakouts
in NHs 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: Applera
Corp – Celera Genomics
(
CRA |
Quote |
Chart |
News |
PowerRating) @9.09 w/11.1 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 we get better breadth
numbers on the downside and better leadership.

The 7/24 low was made with the
strong expectation that central banks would soon clue in to the weakening global
economy and ease. So far the Fed is
indicating that the economy may have enough momentum to continue growing slowly
without intervention, but that he is ready to step on the gas again if economic
statistics start to drift lower again. That
means we may need even more weakening economic statistics to force rate cuts, a
departure from the idea that sparked this rally in the first place.
Global central banks have all shifted toward an easing bias, but few have
yet eased. If the economy does drop
further, will they cut quickly and strongly enough to prevent a return to
recession? And if it doesn’t move
lower, how long will we have to rate for growth to pick up to a pace that will
send earnings and revenue growth to higher levels? And if Bush does invade Iraq,
he’ll probably have about two to three weeks to show apparent victory before
the market reaction is negative.

All these questions add risk,
and risk is what we try to avoid unless we have a clear advantage in these
dynamic global markets. Continue to watch
global bonds, global stocks, and global commodities closely, as this may be the
most important period in your economic lifetime directly ahead.
A renewed crash by stocks, rally by bonds, and decline to new lows in
commodities will likely signal not just global recession re-emerging, but global
deflation for a very long time. We will
continue to try and navigate these treacherous markets aiming for decent gains
with relatively low-risk and safety. Please
stay tuned, now more than ever, and emphasize the importance of patience.

(Charts: New Highs and New Lows
(our charts) , CRA, Daily Sept T-bond chart and S&P chart)