The Difference Between Market Tops and Bottoms

Not so with market tops usually. Lowry’s has done a great job of analyzing this
recently. Tops are broad affairs that show a characteristic NARROWING in the
numbers of stocks and industries that make new highs long before the day that
the indexes make their final highs. It is not uncommon for 1/3 or more of stocks
to have fallen by 20% or more, essentially already in bear markets before the
top in indexes is reached, and for a majority of stocks to have already make
their highs and have turned down by this point. Investors need to get out of
most stocks before the final high is made to optimize results therefore.

Significant tops USUALLY, though certainly not always, are marked by a
substantial divergence in the performance of various groups and stocks
therefore. TM.com investors will remember the market period since 1998 as being
a nearly nirvana environment for long-short strategies because we had huge
pockets of old-industry stocks and groups in bear markets from 1998 on, while a
narrowing list of new-industry stocks kept exploding to new highs — allowing
profitable shorts and longs in breadth, all at the same time.

Yet this week SOME groups are starting to breakdown a bit more — not so much in
major topping formations yet, but substantial enough technical deterioration
that exploratory shorts may be worth considering for aggressive traders, only to
be added to upon substantial further evidence of breakdown. One example is
housing stocks. The HGX housing index COULD be developing the right shoulder of
a one-year head & shoulder top that would be confirmed by a high volume weak
close under 225. On the daily charts, the uptrend line since the October lows
was broken on volume this week. A breakdown on volume under 252 and under the
200 ma would add short-term evidence to suggest a longer-term top possible. XLY
falling under 32 and RTH under 93 to accompany bearish action by housing stocks
would give some credence to the concept of a housing slowdown impacting the
consumer a-bit, something that macro data is starting to suggest is possible
this year. So far retail and consumer discretionary groups have only LAGGED on
the upside, but have not broken down. Utilities and bonds bear watching too and
are in a similar technical condition. Therefore investors need to keep an eye
out for breakdowns by key groups here. The more groups that actually breakdown,
the more dangerous the market environment becomes. To paraphrase Joe Granville,
don’t watch the water line of the top water in the bathtub, watch the suction of
water at the bottom by the drain. The degree of breakdowns and weakness in the
diverging weaker groups here may tell the tale of how toppy this market becomes
and how much hedging and caution will be advised in 2006.

Of course the top groups are way extended and could correct sharply at any time.
But the danger to the top groups may be evident from the action of the weaker
groups. Let’s start watching for continuation and real breakdowns here closely
to see if the market will limp through an economic slowdown of sorts in the US,
or whether defensive action will become more and more necessary.

Our basic strategy of buying strictly only those stocks meeting our rigid
criteria and selling short those doing the same on breakouts has had more new
trades in the last month than in the six months prior, and so far these new
trades are doing quite well.

For those not familiar with our long/short strategies, we suggest you review my
book The Hedge Fund Edge. 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 have continued to suggest more than normal caution and milder than normal
allocation to top global themes, and for investors to expect volatility and less
than optimum markets. There are risks, the Fed is tightening, and a US slowdown
may be materializing. Therefore cautious exposure, trading in and out with minor
trends, is probably yet again the best approach to 2006. We are completing our
“2006 Investment Roadmap” for traders and investors and hope to be able to offer
this to TradingMarkets.com clients soon. We believe it is one of the most
definitive guides to trading in the coming year and it includes our best
analysis of global themes, trends, and expectations for the year as well as what
to watch for changes in the environment. Ask for it from TradingMarkets.com!!

Mark Boucher