The Last Elements Needed To Signal A Catchable Move
On Thursday, the market gave another breadth thrust up,
the third since last summer, with a 90% up volume day. So breadth thrusts are
bullish, liquidity is bullish, the ISM survey is showing a manufacturing
recovery, the dollar is being allowed to decline slowly, providing stimulus to
the US economy, and corporate junk spreads are continuing to narrow. The market
is primed and ready to rally — but new high breadth and group leadership and
follow-through remain the last elements needed to signal a catchable move is
likely and worth playing. Your finger should be on the trigger but don’t fire
significant allocation until you see leadership, stronger new-high
participation, and follow-through among the stocks breaking out and close to
meeting our criteria. It is certainly conceivable and understandable if this
type of evidence does not develop until AFTER there
is a clearer resolution to the Iraq crisis.
Gold, commodities,
and the oil complex are all rallying to new highs. The dollar has clearly broken
down against the Euro, SF, BP, AUD, NZD, and many other currencies. These are
trends most aggressive investors will not want to avoid. Is deflation dead at
this point? Quite possibly, as reflation is a dominant theme in all these new
emerging trends.
Yet realize that the
one wild card remains ever present — war with Iraq and terrorism. Syria, Egypt,
Saudi Arabia, Iran, Palestine and other Arab powers are strongly considering a
launch against Israel upon a US attack of Iraq. Arab media have focused in on
the statements of many religious leaders in the US who have portrayed Muslims
and Mohammed as evil. Sales at US fast-food chains in countries that are more
than half Muslim are down 40% or more vs. prior years in 2002 as Muslims boycott
American products with strong unity. The Muslim world is starting to feel as
though an attack on Iraq is just the first chain link in a plot by the US to
imperialize all of Muslim Arab nations.Saddam has a huge series of palaces in
Libya as well as a nuclear program there and tens of billions of dollars in
hidden cash where he could launch a serious terrorist campaign for years to come
if he left after a scorch-earth exit from Iraq. North Koreas nuclear program is
already linked with those of Iran and Egypt as well as other “axis†powers.
One has to wonder
whether we are on the brink of World War III with a prolonged battle between
Muslim “Axis†powers and the West. The final US ultimatum to Iraq was breached
on New Year’s. Strong evidence exists that several biological warfare cells are
ready to strike key western targets upon US invasion of Iraq. Mid January
through mid February loom as the most likely time for a US invasion, giving
troops time to potentially take most of Iraq before the 130-degree summer season
starts. For weeks US special forces and allies have already been battling in
Iraq in the southeast and north and on both fronts US efforts have been resisted
to a much higher degree than intelligence thought possible, leading many
military experts to expand the expected duration of the war from weeks to
months. The scale of Bush’s list of enemies is so vast that it is not clear what
the plan is for ending this war on terrorism that the Bush team is already
projecting will last more than a decade. Odds still favor a quick victory in
Iraq, but those odds are slipping as more discussions of expanding opposition
mount and as more alternate plans are made by our opponents. Investors
MUST consider the possibility of a much longer and
larger conflict than the markets are anticipating, with potentially wide ranges
of disastrous results. This is a huge enough potential shock that it could
affect literally EVERY investment an investor
makes. Caution is therefore strongly advised until more clarity emerges in this
crisis. Ignoring such a huge potential shock could be disastrous to investment
portfolios, so investors must become as expert as possible on this situation to
properly protect themselves. Of course the
message of the market is still the most critical evidence. If volume,
breadth, leadership, and follow-through can emerge, we still suspect this
rally could develop into the strongest and longest bear-market rally we’ve seen
since the March 2000 peak. But investors need to realize that a geopolitical-war
shock to the markets could reverse on a dime even the broadest based upmove. 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 9 out of 10 traders have been big losers.
Our official model
portfolio overall allocation remains VERY DEFENSIVE. We’re
now 92% in T-bills awaiting new opportunities, with one sole long position.
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 a fraction of a percent for the year 2002.
And we’ve emphasized defense as much as making money.
Unbelievably
Top RS/EPS New Highs have still mustered up just ONE solid week of
consistent +20 or higher readings since the 7/24 lows. Readings since our last
commentary posted just one day above 20 new highs, and no real solid close
calls. New lows at least, have continued to deteriorate. So we remain heavily
on the sidelines — and my guess is this will continue to be the case until there
is some clarity in the Iraqi situation.
For those not
familiar with our long/short strategies, we suggest you review 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 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:
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@40.99 (44.62)-now use 43 ops to lock in profits. 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 leadership and follow-through improve
(soon?). 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: NONE. Continue to watch our NL list
daily and to short any stock meeting our down-fuel criteria 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.
I still would say
that my best guess is that we’re base building for a “B†wave rally that will
last into early 2003 at least. The problem is that international war could alter
this scenario in a heartbeat. Aggressive investors should consider allocating to
gold stocks and resource plays upon continuation of breakouts, as well as
looking to short the dollar and consider deposits in SFs and NZDs. These are
strong trends that few complete portfolios should ignore if they develop
further. But tread lightly in any avenue, as there are almost no investments
that a surprise Iraq development won’t affect. In the US market, WE MUST CONTINUE TO LET THE MARKETS CONFIRM THAT THERE IS ENOUGH STRENGTH TO
SAFELY PARTICIPATE IN THIS RALLY. And that still requires much stronger
evidence of clear new group leadership, substantially more breakouts of
close-calls or stocks meeting our criteria, better and more consistent
follow-through by those close calls and criteria stocks that do breakout, and
substantially more breadth of new highs and breakouts on our list. Watch and
wait for opportunities to improve. Don’t forget that profits can come
VERY QUICKLY when things all line up correctly —
like the nearly 50% gain we took from the late ’99-early 2000 three months. But
patience is required to not give our big gains back in a less-than-optimal
period.
Until next week,
Mark