Trading Range Bottom Fails

• December 22, 2000
• Mark Boucher

Valuations
continue to unwind on the Naz, while the main averages have broken down to
signal a bear market with one exception — the Dow. Now a DJIA brake below 9700 will be critical
— because it will indicate
that a real bear market is developing in every area of the market.
Bellwether Cisco collapsed this week. It is now down 60% from its highs. Cisco
is a good representative of the Nasdaq and Naz 100 in particular.
Cisco is still selling at more than 60 times earnings, while the company
estimates that its long-term growth is more likely to be 30%-40%. Thus, to get to realistic valuations, Cisco could still fall another 50%. To get to bear market bargain valuations, Cisco would have to fall by
another 60%+ from here. Thus, as
long as earnings expectations continue to drop and the economy continues to
weaken without Fed rate-cut help, there is still very high risk to owning Naz
100 stocks, such as Cisco. A bottom
could develop from any point here. But
it is wiser to simply sit back and try to IDENTIFY the bottom after it has
formed, rather than try to PICK the bottom as it is forming. With all but the Dow signaling the possibility of a true bear market,
investors should now become even more risk conscious. 

The
recent bounce off of 11/30 lows has been instructive as to why caution is
important. But as we remarked last week, breadth on the rally was weak. The rally has now failed and stocks are cascading to new lows. Thus, remember that follow-through days alone do not a bull market make. The KEY
ingredient is  the
breadth of leading stocks. Until
dozens of leading stocks are breaking out of sound bases, investors need to turn
their noses up at this market in large part. So far, thank
goodness, this TEST of the market has saved us from jumping
into numerous bear market rallies. If the Dow falls below 9700 and confirms the bear market scenario, investors
should become especially cautious toward the markets. Bear market rallies can be tricky and sharp rallies
can retrace bear
moves of months in a matter of days. But
they inevitably fail, turn back around and head for new lows again. A real bear market is very tricky indeed, and usually lops 50%+ off the
last bull market’s gains. We have
not had a REAL bear market since 1982, when the Dow stood at around 777. So a recession and real bear market could take the Dow down to the
6000-7000 area. We HAVE NOT yet had
a full confirmation that such a bear market is developing. We WILL if the Dow breaks 9700. Until
then, we are still in a viscous trading range. But, investors need to understand the true potential downside if a REAL
bear market does develop. BE
CAUTIOUS!!
 

Let’s
look at some numbers from the week. New
Highs vs. New Lows on our RS/EPS lists were 11/17, 11/27, 33/31,
35/45 and
15/78, as new lows regained some
dominance over new highs this week, though not clear and substantial dominance. There were roughly
nine breakouts on the upside with eight breakdowns on the
downside of four-week-plus consolidations on our RS/EPS lists. However, most importantly, there were no valid breakouts on the upside in
upfuel stocks and no valid breakdowns on the downside in downfuel stocks. Close calls on the upside were seen in
Penn Virginia
(
PVA |
Quote |
Chart |
News |
PowerRating). The market is still not giving us many trading opportunities, and is
therefore still warning us to be cautious — and at this point, we should be
happy with this continued signal. There
is not a lot of low fruit to pick in this market.Our
overall allocation remains super low. We
are now around 10% long (including open profits) and 0% short for aggressive
accounts using leverage (5% long and 0% short for unleveraged, more conservative
accounts). Last week our lone long
Downey Financial
(
DSL |
Quote |
Chart |
News |
PowerRating) soared by over 19% (and with 9% allocation this added 1.7% to our overall
portfolio), while we had no shorts, giving our overall portfolio a gain of
around 1.7% on the week and leaving us with around an 83.97% gain on the year (a
new equity high!!!) on a 12% maximum drawdown so far. Conservative investors not using leverage show about half these gains and
drawdowns. Yes, we are making very
slow progress in this market, but investors have to be happy with new equity
highs in this environment. We have
kept our gains, avoided the carnage, and continue to slowly step up to higher
profits in one of the most difficult environments in decades. Investors should chart our equity along with the markets’ and put it up on
the wall. Then when we have a
period of underperformance sometime in the future, refer to this period to give
you confidence that our long-term out-performance is worth waiting through the
inevitable periods of underperformance. Managing
to avoid both the bloodshed and the volatility many other strategies have shown
here is actually even more important than cleaning up from the big moves up.

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 and course “The Science of Trading.” 
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. 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
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.Upside
breakouts meeting upfuel criteria (and still open positions) so far this year
are:  Downey Financial
(
DSL |
Quote |
Chart |
News |
PowerRating)
@45.25 w/47 ops; and last week we had no valid pattern breakouts up in stocks
meeting our up-fuel criteria (see 10-week trading course). The average gain
in these stocks from breakout points of entry to Wednesday’s close is 87%,
substantially outperforming the NASDAQ, DOW and S&P for the year to date. Continue to watch our NH list and buy flags or cup-and-handle breakouts
in NH’s meeting our up fuel criteria — but continue to add just two per week.

 

On
the downside, 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: no open
positions at the moment; And
this last week we had no valid pattern breakdowns in stocks meeting our
down-fuel criteria (see 10-week trading course). These shorts are down over 59% from breakdown levels on average so
far this year (before current prices or exits). 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. Here,
too, remain cautious by only adding two shorts in a week.When
you don’t get killed by the bear moves, you can wait patiently until it is SAFE
to enter before getting in. DON’T
WORRY ABOUT MISSING THE BULL MOVE. If
it develops, we will be late, but will catch up by selecting the leaders that are
breaking out of solid patterns. The
name of the game is to make money and defend gains, not to pick bottoms and
tops. Only when our opportunities grow to become abundant will we be able to
get more excited about moving our long allocation or short allocation up to more
aggressive levels.We
have had a spectacular year following this strategy in year 2000! I hope investors have both been able to profit and been able to avoid the
carnage from the big declines since March. We will be taking a deserved Christmas vacation next week, and our
next update will be during the first week of January. I would like to take this opportunity to wish all TradingMarkets.com
subscribers a very happy holiday season. May
2001 be as generous to us all as 2000 has been!!!!

Regards,

Mark
Boucher