Time Ticking Away As Fed Tightening Draws Near

  • April 5, 2002
  • Mark Boucher

The
fed funds rate stands at 1 3/4%, well below neutral levels of 3.5%
minimum. The Fed has removed its easing
bias, and a tightening phase swinging rates back to neutral and perhaps beyond
looms in late spring or early summer.
Fed funds futures currently discount a 75 bp hike in rates in the next
six months and over 200 bp’s over the next year.
Expectations usually escalate on the first rate hike. 

The Fed’s aggressive
stimulative policy DID successfully limit some of
the downside economic damage after the tech bubble burst, but unfortunately,
high valuations were preserved as a result. The
developed markets therefore likely have one more chance to rally before policy
begins its tightening phase and a ceiling is put on stock prices.
The problem is that just as overvalued stocks did not respond well to
rate cuts and the S&P has essentially been flat to lower since the Fed
started its historic easing phase, overvalued stocks are also most sensitive to
rate hikes very early on in the tightening phase.
Excessive valuations cannot stand rate hikes.

The best performing asset class
so far has been Emerging Markets. There
are many reasons to suspect that EMs will remain stronger and that the bull
market will remain more durable than in developed markets.
EMs are still undervalued vs. their prospective growth rates and their
historical mean. They have just
experienced a bear market taking 70%+ in value off of them since 1994.
Government and corporate policy has shifted in this long bear market to
improve profitability. EM stocks in
Latin America — where resource-dominated commodity companies are more dominant
— will be the prime beneficiaries of the second phase of the economic recovery,
when commodity price strength will feed through to corporate earnings.
EMs are prime beneficiaries of reflation and inflation — and any
flare-up will benefit them. Portfolios
are beginning a historic shift into EMs as an asset class.
Aggressive investors are thus still encouraged to emphasize EMs in their
portfolios until more growth stocks breakout and allow replacement.

Top
RS/EPS New Highs couldn’t even manage
to break the 20-per-day mark that we watch for as breakout numbers continued to
deteriorate. The number ofBottom
RS/EPS New Lows this week continues to be pathetic as well, giving us few
new opportunities at the moment.

Our overall
allocation remains DEFENSIVE, with 76% in T-bills
awaiting new opportunities. 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 about 3.5% for the year 2002.
We still think that our long/short strategy in growth stocks with decent value
will be able to realize decent returns this year. But understand the U.S. market
is likely to be volatile, and our approach will not be able to avoid some of
that volatility — so expect more frequent and larger drawdowns than we’ve
had so far.

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: Crown
Group, now
(
CRMT |
Quote |
Chart |
News |
PowerRating) on conversion @8.60 (11.4) w/9 ops; Garan
(
GAN |
Quote |
Chart |
News |
PowerRating) @45.60 (55.1) w/48 ops; and Lands End
(
LE |
Quote |
Chart |
News |
PowerRating) @52 (43.34) w/42.50 ops. 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.

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 (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.

Again, we encourage
investors to act globally and become more active in emerging markets and
gradually in developed nations. The U.S. market needs to clear its resistance
levels to become more bullish than we have been. This may not happen for weeks
or even months and may need a catalyst such as the Fed’s announcement in May.