There Is No Other Choice Than To Use Caution With Investment Allocations
Cautious
Advance
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The market has begun a sizeable
rally this past week in what could be a retest of December’s market highs. What
is somewhat encouraging about the developing rally is that it is displaying less
strength of breadth than would be typical of a late stage rally and market top.
History shows that market tops usually happen at times of euphoria and
complacency towards risk, a stage that we have not hit yet. Nonetheless, we
caution that the current advance in equity markets is occurring at a time when
the Fed is hiking interest rates. Times of rising Fed interest rates usually
coincide with contracting PE multiples and falling profit margins, which
correlates directly with lower equity prices. Therefore, although the market is
showing strength and it is tempting to try to catch a rally to new highs, there
is no other choice than to use caution with investment allocations.
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Particularly in such an
environment, we like portfolios that are hedged 50/50, long/short. Our favorite
groups during a rising Fed funds rate environment are defensive in nature. In
general, we like large caps over small caps. Small caps have been on a tear
during the equity bull market since the summer of 2002, have significantly
outperformed large caps, and are now trading at substantial price to earnings
premiums in comparison with large caps. As PE multiples contract, small caps
should naturally fall more than large caps since they have higher PE multiples.
Additionally, in times of market weakness, investors tend to go for names that
they know and where they feel safe; these names are almost always in the largest
capitalization stocks.The broadest way to play this trade is by using various
iShares such as taking NY (NYSE 100) long over IJR (S&P Smallcap 600) short.
Using the broad iShare index funds allows you to ignore the intricate
fundamentals of each large and small cap company that you would use in a pair
trade and concentrate the performance of the trade where you want it — at the
macro level as opposed to the micro level. Other defensive sectors that we
expect to outperform include Energy (IVE) and Healthcare (IYH). We like these
defensive sectors long over the broad market short (SPY or QQQQ).
Our model portfolio followed in TradingMarkets.com with specific
entry/exit/ops levels from 1999 through May of 2003 was up 41% in 1999, 82% in
2000, 16.5% in 2001, 7.58% in 2002, and we stopped specific recommendations up
around 5% in May 2003 (strict following of our US only methodologies should have
had portfolios up 17% for the year 2003) — all on worst drawdown of under 7%.
This did not include our foreign stock recommendations that had spectacular
performance in 2003.Â
This week in our Top RS/EPS New Highs list published on
TradingMarkets.com, we had readings of 54, 102, 129, 111, and 107 with 33
breakouts of 4+ week ranges, no valid trades and close calls in NRG, ERJ, BF,
AKS, and ACP. This week, our bottom RS/EPS New Lows recorded readings of 18,
10, 5, 7, and 8 with 7 breakdowns of a 4+ week ranges, no valid trades and one
close call in FSS. Valid signals remain in place in MLI, BHP, USAP, LCAV, and
JBLU. The balance of longs and shorts and breadth in top RS NH’s versus bottom
RS NL’s has now clearly shifted back towards a positive biased environment.
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, the
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 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 have been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.
Mark Boucher