The Lack Of Follow-Through Days Suggests This…

• May 2, 2003
• Mark Boucher

The underlying market internals have improved,
and further follow-through up and breakouts by the averages will confirm a
catchable upmove of unknown duration. This past week, the market cleared the
March-April resistance levels of 910 in the S&P 500
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Dow
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broke its March-April resistance of 8850, but has
since dropped below this level. 

Although our short-term
indicators are indicating an extended market in the up-move since mid-March, our
intermediate-term indicators are confirming a bear-market rally. We continue to
suspect that this bear-market rally will be of stronger and longer duration than
any since the 99-2000 peak. A rally of up to a year erratically moving higher
before stagflation hits the market is possible. But regardless of unknown
length, a bull move that appears catchable seems to be under way. The first big
test is how it behaves at prior resistance. 

So as the Dow, Naz, and S&P
approach resistance that has held since the rally of late 2002, look for some
consolidation, at the very least. Consolidation followed by high volume
breakouts with a strong close and continued good breadth would likely mean a
further decent move in the wings. Are we finally getting something here?  Time
and market action will tell the tale.

More than half of the equity
indices of the developed world have risen above their 40-week averages and are
starting to show some follow through. Corporate bonds have rallied strongly and
corporate bond spreads have narrowed significantly, confirming that investors
are viewing corporate restructuring efforts favorably and that business
conditions have stopped worsening.

In general, first-quarter
earnings announcements out of leading companies have beaten estimates (although
estimates were very low), and companies have issued positive guidance going
forward. The lack of follow-through days amidst such positive news suggests that
investors will take a “show me” attitude towards earnings performance going
forward in 2003. 

Leading economic indicators
(particularly first-quarter GDP growth and the ISM) have actually come
in below consensus this week, and investors are sorting out whether the economic
weakness was due to the war in Iraq or deep underlying problems in the US and
world economies. The dollar is hitting four-year lows against the euro as the US
account deficit continues to widen while the euro zone is running a
surplus. Hints by the Federal Reserve that they could possibly drop interest
rates further have only contributed further to this trend. 

Investors have fully factored
in the positive news coming from Iraq and the War on Terrorism, and any shocks
could throw the market for a loop. The world hopes for good news out of peace
talks in Northern Korea and Israel/Palestine, but seems to show no shock in
whichever direction negotiations go. Luckily, SARS has not become a global
epidemic yet; Canada and Vietnam have managed to contain the virus by
quarantining those exposed. Watch May 8 as a key indicator of China’s success in
maintaining the illness — that marks the date schools re-open and the one- to
two-week incubation period of the virus, and therefore will show if quarantine
efforts are working. 

We therefore continue to
suggest that investors cautiously add exposure as trade signals are generated,
although a good-volume strong break above the resistance levels could turn us
more aggressively bullish.  Wait for more confirmation.

Since March 2000, the world index is down over 43%, the
S&P over 40%, the IBD mutual fund index is
down over 60%, and the Nasdaq has crashed over 70%. Meanwhile since March 2000
the long/short strategy we summarize and follow-up each week in this column has
made more than 44% 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 9 out of 10 traders have been big losers. 

Our official model portfolio
overall allocation remains SOMEWHAT DEFENSIVE. We’re
now 32% long and 8% short, with 76% cash in T-bills (short-sale cash included,
four longs and one short at 8% each) awaiting new opportunities. Our
model portfolio followed up weekly in this column was up 41% in 1999, up 82% in
2000, up 16.5% in 2001, and up 7.58% in 2002, an average annual gain of over 36%
— all on a worst drawdown of around 12%. We’re now up 4.46% for
the year 2003.   

This past week our daily

Top RS/EPS New Highs registered its second week of 20 or greater new 52-week
highs since 7/24.  This market action gives us greater confidence that the
environment is now turning better from a long-side perspective. Bottom RS/EPS
New Lows have been nearly non-existent since mid-April. We had readings of 45,
21, 72, 73, and 64 in our Top RS/EPS New Highs list, accompanied by 18 breakouts
of a 4+ week range, no valid trades and some close calls in
Corinthian Colleges
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North Coast Energy
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and Duratek
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We have been lucky enough to
take advantage of strong breakout opportunities that have presented themselves
in the past month and await further opportunities if the market can remain
strong.  Bottom RS/EPS New Lows last week showed low readings of 3, 5, 8,
3, and 1, with only 3 breakdowns of 4+ week patterns with no close calls. Let’s
see if the high ratio of new highs to new lows continues as we hit some key
market resistance levels.

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, and

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 US 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:
Garmin
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 @34.79 (42.38) now use 38 ops; and STET
Hellas Telecommunications, S.A.
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ops.

Also, Avid Technology 
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Cyberonics
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(22.83) w/ 20.5 ops. Continue to watch our NH list and buy flags or
cup-and-handle breakouts in NH’s meeting our up-fuel criteria — we’ll continue
to advise adding only two stocks per week that are in clearly leading groups
until we get clear breakouts in all the averages.

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
Brooks Automation
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@8.46 (8.47) w/ 10.6 ops. Continue to watch our NL list daily and to short any
stock meeting our down-fuel criteria (see

interactive training module) 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.

Investors and traders should be
getting more excited about the environment on the long side. However be patient
and be sure to only buy strong breakouts that meet all of our criteria. If
indeed a multi-month bull move is in the making, the best trades are yet to
come, and waiting for valid breakouts will allow you to substantially beat the
moves of the averages, even though most trades come after the move is well on
its way. Continue to watch for confirmation that the war has ended soon enough
to prevent a global recession. Let’s hope better times are just starting to
materialize here.

Mark Boucher