This Question Is Critical To The Investment Outlook In The Months Ahead

• September 3, 2004
• Mark Boucher

Global
Deceleration — to end or not to end, that is the question

By now global financial markets
have discounted and fully recognized the emerging economic deceleration that
we’ve been talking about for months.  So far it further APPEARS that global
markets are anticipating an end to this slowdown via many market signals we will
discuss below.  However the market’s actions are not yet fully definitive. 
Investors must recognize that the question of whether the deceleration ends or
continues is absolutely critical to the investment outlook in the months ahead.

The global economic slowdown
has contributed to a correction in global bourses.  From their peaks of this
year, the world index has dropped 9%, the NAZ more than 15%, and EM indexes over
20%.  These declines have pretty well discounted the slowdown that has developed
thus far.  Yet if the slowdown continues to degenerate into recession, recent
declines will look like a picnic in retrospect.  Global share prices would
likely drop much more significantly from here if the globe were to move toward
recession.  Conversely, a temporary deceleration that stalls here would likely
allow global equities to stabilize and resume the advance began last March. 
Therefore the outcome of the question of whether the growth slowdown ends here
or not is critical to the investment environment ahead.

So far a small plurality of
market movements and indicators seem to be suggesting that the deceleration will
end soon.  We will discuss what markets to watch and why this is our
interpretation presently.  However we also want investors to fully understand
how precarious the current situation is.  A major shock could derail the
stabilization process and push the global economy toward recession. 
Unfortunately we are in a period of time where a major shock (either from
terrorism or further oil price rises) is more likely than perhaps ever before
(leading up the election). 

Generally when a significant
slowdown develops a number of markets show the footprint.  For Example, EM debt
spreads widen and junk spreads versus Treasuries widen significantly, as the
risk premium inherent in higher risk debts grow.  So far we have not seen a
widening of quality yield spreads, and in fact they have narrowed, indicating
that bond investors are not yet anticipating a substantial further weakening of
economic growth.   Industrial commodity prices corrected ahead of the slowdown
but have now stabilized and are inching higher, after hitting 40 week ma support
and basing.  The Baltic Dry index, often a bit leading of industrial commodities
has likewise turned up.  Emerging markets also turned down in anticipation of
the slowdown.  Yet EM equity indexes held up well during the recent downturn in
developed market equities and are actually leading the way higher now.  The most
economically sensitive areas, such as Asia, are showing outperformance versus
the globe as well.  China’s tightening has slowed and its growth has stabilized
somewhat.  Thus some key measures of market anticipation of further weakness are
NOT developing and on balance the markets appear to be anticipating a
stabilization or reversal of the deceleration.  But investors need to watch
yield spread, raw commodity indices, EM equities, and Asia relative to the world
closely to monitor whether these trends continue or reverse sharply.  In
addition, investors need to watch, what we have called the triple threat since
early this year — bonds, oil, and the dollar.

It is true, as we commented
last week, that several countries have already capitulated and started cutting
rates — Brazil, Hungary, Korea, and South Africa, for example.  But it is also
true that other countries recently raised rates, like — Mexico, Poland, and
Thailand.  The real question that may determine the outcome of whether this
global slowdown stalls or turns into a protracted slump, may hinge on how the
Fed reacts.  We believe a poor employment report this Friday SHOULD force the
Fed to tone down its tightening rhetoric and lead the markets to discount a
slower pace of tightening.  Yet investors need to be very watchful of the Fed
here.  If he tones down his tightening rhetoric and admits that the economy is
decelerating and he may not tighten as quickly as he previously suggested, then
stocks should do better and the deceleration should stabilize.  If the Fed keeps
sounding hawkish in the face of weaker economic reports, markets will be in
trouble and the deceleration could continue and turn into something nastier.

I would be remiss in not
pointing out that in the midst of the knife-edge period of time economically, it
seems likely that al Qaeda will at least ATTEMPT something prior to the US
election.  Investors and traders need to remember that a shock could erupt from
this source any time and perhaps not during market trading hours — leading to a
higher potential for gaps from an exogenous event than at any time in recent
memory.  So tread carefully here and consider that stops may not be the correct
picture of the real risk of any trade that is not market neutral.

Despite some minor trading
opportunities and some relative long/short sector trading opportunities, we
continue to recommend a cautious stance toward equities, and heavy allocation to
other asset classes in general. 

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. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 42, 28, 29, 39, and 74 with 24 breakouts of 4+ week ranges, no
valid trades and one close call in SYT.  Valid trades appear open in CETV and
MLI.  Breadth is expanding again and more close calls would be a call to add
some long exposure.  Position in valid 4+ week trading range breakouts on stocks
meeting our criteria or in close calls that are in clearly leading industries,
in a diversified fashion.  This week, our bottom RS/EPS New Lows recorded
readings of 6, 6, 5, 8, and 4 with 3 breakdowns of 4+ week ranges, no valid
trades and close calls in AHO and PWER.  We’re still not getting a lot of
trading signals in valid breakouts, though the environment is improving slightly
on the short side.

 

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’ve been effectively
defensive ever since, and did not get to a fully allocated long exposure even
during the 2003 rally.

While some minor opportunities are developing that may lead to small moves that
could be played by short-term nimble traders, the environment is not yet clearly
advantageous, and so we continue to suggest high allocations to cash and other
assets and a low allocation to equities.  Sometimes it is hard to be patient,
but wise.

Mark Boucher