The First Sign Of A Catchable Rally…

  • August 9, 2002
  • Mark Boucher


Following July 24’s big reversal
day, we have been
anxiously awaiting a breadth thrust or a follow-through day as the first sign
that a possibly-catchable bear market rally will emerge off of extreme oversold
and overdone sentiment levels. This week, we did have a feeble follow-through
day, but it was late (beyond four to seven days after the low) and volume was
below-average, though higher than the prior day. That means it probably won’t be
safe to enter the market until we get another follow-through day, this time on
higher-than-average volume. No breadth thrust yet either. 

Continue to watch for breadth thrusts like:

  • a 9:1 up/down
    volume day

  • a 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

In this type of
market, we have to be very mindful that the market can do anything anytime — so
watch and let it signal to you with its own action what it is likely to do in
the period ahead. However, our best guess is that sometime this fall (perhaps
already) we will get an intermediate-term bottom that will lead to a catchable
rally, maybe even the best quality rally we’ve had since March 2000. 

But sometime in the first half of next year, this rally is likely to face
headwinds and turn back down for at least a retest, and likely a break of the
lows of this summer/fall. Wait for more follow-through and some better breadth
in our new high list and some leadership in terms of groups breaking out of
sound bases before trying to play this rally or any other that starts this fall.

As mentioned previously, another thing this market needs to be able to prove it
can do before a decent rally develops is shrug off some probably weaker economic
news and some negative earnings surprises. So far, this type of strength in the
face of bad news is not yet developing. 

Right now, global markets are discounting more rate cuts ahead. The question
though, is whether these new rate cuts will be any less temporary in effect than
the prior historically sharp and quick rate cuts. Since a surprise rate-cut
could temporarily lead to a sharp rally, but a lack thereof along with worsening
economic news could lead to new lows, the environment is not reliable and is
dangerous both for shorts and for longs. 

In trading and investing you’ve got to know when to hold ‘em and know when to
fold ‘em, know when to walk away, and know when to run. The current environment
is difficult and uncertain, so allocations should be very low.  Wait for low,
ripe fruit before wasting your time and capital here. This is one of those times
when cash looks good. Let’s hope we get some market action that changes that
soon, but until then, let’s enjoy the sidelines. 


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 since then of under 6%. 

Now clearly we are
underperforming our long-term growth rate during this period, and it is hardly
thrilling to have been so heavily in cash since March of 2000. But investors
have to realize that keeping risk low and slowly building less than average
gains in a dangerous environment is still a big victory for any strategy when 9
out of 10 investors are getting killed. 

Sometimes just playing good defense is the most important aspect of winning the
game.  Unfortunately we’re still in one of those periods. But even if this bear
market lasts many years longer and we get a decade of mini-bull and mini-bear
markets, investors using this strategy should be able to do quite well via this
strategy with minimal risk. 

Remember low-risk investing is streaky — there are periods of substantial gains
(41% in 1999 and then 82% in 2000), and there are periods of less impressive
ones. But if your average returns are over 20% and you can keep risk and
volatility to a minimum, your accomplishing your goals and your doubling your
money every 3.5 years (taxes not considered). And that’s worth getting excited
about! 

So yes, this may not be the most fun period investors have ever faced, but
maintain your discipline and your defense, and the next time we get the ball by
getting a better investing environment, we’ll be able to go after opportunities
with confidence to produce steep gains again and again. 

Sometimes doing nothing is the most difficult thing of all to do. I’m sure that
many traders are tempted to play close call trades, even if it is with less than
normal allocation. And you can certainly do so, AS LONG AS
YOU BALANCE SHORTS AGAINST LONGS UNTIL WE GET SOME CLEAR SIGNALS THAT A
CATCHABLE RALLY IS EMERGING. But realize that in this type of
environment, one may end up lucky to break even on close call trades in total,
and it is unlikely that the profits will be worth the effort. 

We continue to expect 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 on both the upside and downside. 


Top RS/EPS New Highs did NOT strengthen this week, and remain weakly below
20 a day consistently with readings of 6, 7, 4, 4, and 9 (even fewer than the
prior week). We would typically expect a better rebound in new lows off of a
potential bottom.Wait now for at least a SOUND
follow-through day before anticipating even a multi-week rally. And wait for
solid leadership in the breakouts before thinking about getting aggressive on
the long side.

Bottom RS/EPS New Lows expanded this week and stayed solidly above 20 with
readings of 47, 97, 167, 42, and 45.  

The trend still looks to be down until proven otherwise, despite the incredible
degree of overdone sentiment and oversold levels and a meager follow-through
day. The breakout and breakdown numbers are still weak on both sides of the
tape, meaning few even potential opportunities compared to a more typically
abundant environment.  Sometimes heavily on the sidelines truly is the best
place to be. There will be plenty of good opportunities when the environment
changes, so be patient.

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 5.7% 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 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 Arrow
(
ARW |
Quote |
Chart |
News |
PowerRating) @17.97
(16.27) w/ an 18.2 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 volatility is more normalized.

 

The
major and most critical question  regarding the markets is still unanswered, but
now getting closer to being so.  That question is whether this new bear market
leg will actually carry to global recovery down the toilet into global recession
and a very negative scenario. Bond markets and commodity markets are starting to
signal renewed economic weakness. The question is whether the Fed and other
central banks will lower rates now quickly enough to avert a major catastrophe
economically.

The longer question is whether rate cuts will do any more than delay and
draw-out the pain. We suspect they will engineer another saving attempt at least
because Greenspan knows the danger and the cost. Will he save us from a brutal
global recession now and further global deflationary disaster?

Continue to watch global bonds, global stocks, and global commodities closely
though, 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.

Mark