Wait For Breadth To Confirm Rally

• October 18, 2002
• Mark Boucher

Last week, sentiment indexes got as overdone as they have
been in many years on average. Investor’s Intelligence bulls vs. bears
showed the most bearish reading since the October 1998 low. The market became
vulnerable to any shift in psychology and when a rally started, it was able to
draw short-covering and bottom-picking alike.

Is this the low we’ve been expecting this fall-winter from
which a catchable rally of better duration and size than any since 2000 will
develop? So far, it’s difficult to know. Breadth has been decent. We nearly
got a 9/1 upvolume/downvolume day and we did get a follow-through day. Trouble
is, we’ve had lots of follow-through days on nearly every bear-market rally.
What we really need to see now is broad participation and leadership. We need
significant expanding of our Top RS/EPS new highs with lots of breakouts and
some industries to begin to clearly dominate those lists. So far HMOs and
various medical groups appear to be offering some leadership, but that’s pretty
much it.

We still suspect that before this rally develops the teeth
necessary to propel some real growth stocks and groups significantly higher
(which is what we would call a catchable rally and one worth participating in)
we will either need to see some clarity in the Iraq situation and/or monetary
easing. We suspect the Fed will ease on Nov. 6. Right now, the markets are
rallying partly in expectation of this easing. But if the Fed doesn’t actually
deliver, the rally could fall apart again. Watch carefully for broad-base
breakouts on a large number of stocks before considering that a decent low has
developed. So far this is possible, but not clear.

Many novice investors unfamiliar with trading growth-stock
breakouts will, at this stage, get frustrated and worry about missing the move.
“The Naz is already up like 18%, so what are you going to do, now that you’ve
missed the bottom?” one reader writes in. The beauty of trading growth stocks
is that you don’t try to catch bottoms. Instead you wait and watch carefully
and when you get enough breadth, leadership, and breakouts in leading stocks, you
begin to selectively participate. 

And the great thing is that you’re able to
outperform any decently sized and durable rally on the upside because of
superior selection and substantial outperformance on your selections, even
though you will definitely be “late” to start participating in the rally. This
allows one to trade with more patience and to miss many of the rallies that
appear decent and turn into bear market rallies that are too short to really
participate in. So don’t worry about the market “getting away from us,” and
just watch carefully to determine if we are getting the breadth, the leadership,
the breakouts, and the setups we need to start moving more aggressively toward
the buy side.

Continue to watch for clues that reflation is working on
the US market over the intermediate-term, like a breadth thrust such as a 9:1
up/down volume day, the 5-day moving average of advancing volume to be 77% or
more of total volume, an 11-day A/D ratio of 1.9 or more, or a 10-day A/D ratio
of 2 or more. More importantly, look for a substantial broadening of the
number of top RS/EPS new highs on our lists, accompanied by stocks at least
close to meeting our criteria breaking out of 4-week+ consolidation patterns to
new highs in abundance.

One key that suggests this rally may continue is the
short-term triple top that the bond market has broken down out of. While the
objective of this pattern has already been hit, and is very close at hand in the
10-year bonds, this pattern could lead to a longer and larger decline that would
help confirm the rally in stocks is for real and is one of the indications we
have been watching and waiting for. Remember that in a deflationary
environment, bonds will need to DECLINE to fuel a rally in stocks, as both
are simply reacting to changes in economic growth perceptions.

Corporate yield spreads are still levels that are
discounting a near-depression, and for this rally to hold, yields on junk bonds
will have to narrow vs. treasuries. Bombed-out European markets are in sync
with the US rally, but investors should also look for much broader
international participation to develop in a meaningful and durable rally than
has thus far been apparent. Russian and Eastern European markets remained
strong through the decline and are leading the rally, for those wanting to look
where to participate globally.

Investors also need to keep watching oil prices, which have
acted like monetary tightening upon the global recovery. A substantial rise in
oil prices could kill this market, while a substantial decline in response to
positive Middle East developments, could propel the market substantially
higher. Other commodity prices continue to show a mixed picture. Lumber
appears to have put in an intermediate-term bottom, and copper is rallying.
Look for more upside in these economically sensitive commodities before getting
too aggressive on the long side.

Investors need to realize that until we get solid
indications of real leadership and breadth, despite sharp rallies from oversold
conditions, this remains a very treacherous market environment. There is
now good reason for hope that a change is developing — but until that change is
clear, caution should continue to be paramount. Many shorts got killed on this
rally off of 10/10, while anyone long nearly anything since late August has felt
pain and volatility as well. Avoiding this carnage is a key to successfully
producing substantial gains with acceptable risk, which is the goal of any
investment plan.

We remain watchful and hopeful that this rally materializes
into something that can provide decent long-side opportunities, but until we get
more evidence of leadership and breadth, our strategy remains ultra-defensive,
but continues to slug out small gains.
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 nine out of 10 traders have been big losers. We will hope and
watch for a better environment, but wait patiently until it arrives before
risking significant capital.

Our official model portfolio overall allocation remains

EXTREMELY DEFENSIVE. We’re now 100% 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 around 6.11% for the year 2002. Let’s wait for a bit better
environment before positioning heavily.

What are we talking about in terms of better breadth?

Top RS/EPS New Highs have still never mustered up one single solid week of
consistent +20 or higher readings since the 7/24 lows, let alone since 10/10
lows. Readings this week were improved, but hardly indicative of broad-based
participation at 7, 11, 11, 29, and 10. However we did get 16 breakouts of 4+
week consolidations within these new highs, and even got a couple questionable
close calls. While this isn’t yet close to what we’re looking for, at this
stage of the rally, it’s as much as we could expect. Let’s see if we can get
20+ breakouts consistently over the next week accompanied by even more breakouts
that show consistent group leadership. 

Bottom RS/EPS New Lows finally dropped to below 20 consistently, helping to
confirm the rally with readings of 219, 23, 22, 7, and 27. Let’s see if we can
get a week of consistently under 20 to confirm that new highs are starting to
clearly dominate. New lows were accompanied by just 4 breakdowns of 4+ week
consolidations, the lowest number in some time, with no close calls. Notice
that our analysis of new low breakout quality helped keep us from getting
trapped on the overly bearish side of the market in the decline from late
August.

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 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: NONE. 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 the market environment improves.

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. We were short
(
CRA |
Quote |
Chart |
News |
PowerRating)
@9.09 — and were stopped out on our trailing stop with a slight profit at 8.76
on a gap above our 8.5 ops this week. 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
downsid, 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.

So far, there have been many false starts to investors
waiting for some catchable action on the upside in the market. Is this another
sharp fake-out bear rally, or is this the fall-winter low we’ve been waiting for
and talking about for months? Let’s wait, watch, and let our indicators that
have guided us so well thus far, be our guide. We want to catch a reliable and
durable move and yet avoid anything that isn’t reliable or durable. There are
still HUGE potential risks in this market and both bulls and bears are getting
chewed up in this environment. But now is a good time to begin watching our new
high lists carefully for indications of potential breakouts of stocks meeting
our criteria, and for evidence that leadership and broader participation is
developing.

Mark