Waiting For Iraq
Friday will likely be a key day
for the markets. Hans Blix is due to give his analysis of Iraqi
compliance with UN 1441. We’re getting leaks that missiles beyond the range
allowed by Iraq have been found. Iraq has flatly refused German and French
suggestions for more inspectors and UN troops. The Iraqi refusal is a blessing
in disguise. Investors will remember that in the Kuwait war Iraq took UN
inspectors hostage. Putting more of them at the disposal of Saddam was a way of
giving Saddam ransom and trying to prevent the war through potential blackmail.
It didn’t work. It is probable that we are 1-4 weeks away from the beginning of
war. Saturday’s NATO meeting will also be critical — the wind is blowing toward
Germany, France, and Belgium conceding more defensive weapons to Turkey and
agreeing with the other 16 of 19 NATO members, who support such action
immediately (and who also support the US position in the UN, by the way).
We’re getting a lot of questions from people about how to
“play†the war. To my mind the answer is either “hedge†both directions if you
have significant exposure you can’t unwind, or preferably if you don’t have
large exposure — DON’T play the war at all. As
investors, our job is to find situations with high reliability and the potential
to return many times what we risk if our analysis of a highly reliable situation
turns out correct vs. if
it doesn’t. To me this CLEARLY does
NOT describe the onset of war at this
time. Even top military experts admit that they cannot predict with any kind of
reliability whether Saddam or anyone else will be able to wreak terrorist havoc
or damage major oil fields. That means the reliability is not there for
ANYONE.
Investors may well be bored with sitting on the sidelines, but trying to play a
potentially volatile and unreliable situation while bored is an investing
mistake, whether you make money from it this time or not, in my opinion.
Investors are also too heavily focused on using the Gulf
War as a yardstick for how the markets will react, in my opinion. In August of
1990, Iraq invaded Kuwait and the S&P dropped from around 370 to 290 over the
next three months, a drop of around 22%. Stocks range-traded until January when
the US invaded. It is true that the S&P rallied sharply by around 23% over the
next three months, while the Naz rose over 30%. In addition, the type of leading
stocks in leading industries displaying fuel characteristics we look for took
off and never looked back. We got lots of good profitable signals following the
gulf war that made 1990 an excellent year for those following our methodologies.
However, as important to WHAT happened in the Gulf War is a
thorough understanding of WHY it happened then, and what is
DIFFERENT THIS
TIME. Before the Gulf War, many military and investment analysts feared that any
US involvement would lead to a new Vietnam, where the US would be dragged in to
the conflict for many years. Investor’s Intelligence percentage of bears
remained at 50% and higher during nearly the entire period between the Iraqi
attack and the US invasion. Mutual fund cash levels soared to 13%, nearly the
highest levels in history. The general public was frightened about a potential
new Vietnam-type outcome and had no idea that the Gulf War would end so soon and
be such an incredibly overwhelming success.
Therefore, when Iraq turned tail and retreated without a fight at all, and the
war was “won†literally in a matter of days, it was a complete shock to the
market — and this positive shock along with the quick and resounding victory and
end to the war led to an explosive rally out of overly negative sentiment.
Investors should note that there are some notable
differences between the Gulf War and the Iraq War developing now. This time,
almost all observers are anticipating another decisive and quick victory. Such
a decisive victory could push stocks up a bit in relief certainly, as well as
help turn consumer sentiment and capital goods orders around. The recovery that
has been starting could truly develop. But the shock to the market would likely
be substantially less than during the Gulf War, when no one was expecting a
resounding and quick victory. Investor sentiment is NOT bearish right now, as
it was in the Gulf War. Bullish sentiment is around 50% and bearish sentiment
is historically rather low, just the opposite of the Gulf War. Mutual fund cash
today is 4.6%, historically very low, not at all-time highs as it was prior to
the Gulf War. Prior to the Gulf War, investors were extremely frightened and
cautious — but today they can best be described as complacent and expecting a
quick positive outcome to the conflict. This means that if there is any result
less optimistic than investors are expecting, the shock could be on the
downside, while positive shocks are likely to have significantly less impact.
With historically low cash levels, mutual funds could be forced to sell stocks
to meet redemptions if there is a negative shock geopolitically.
Finally the President’s report to Congress estimated that
the War on Terrorism will last for more than a decade. Iraq, even if it is a
quick conflict, will not be the end of the war, and this conflict IS
truly
likely to be more Vietnam-like, in that it will go on and on and on. When the
Gulf War began, the market was in the midst of a secular bull market. Today, the
market is in the midst of a secular bear market — where typically surprises are
on the negative side.
Therefore we not only have a very different situation today
than the Gulf War, but also are in a different environment where the market has
different expectations. A quick and decisive victory could launch the global
economic recovery into full steam and lead to a mini-bull move in stocks until
inflationary pressures begin, likely MUCH more quickly than anyone is currently
imagining. Anything less than a quick and decisive victory, and any negative
shocks, is likely to disappoint the markets, perhaps significantly. We don’t
think this sets up a good risk/reward in either direction.
Nonetheless, for those who have exposure they cannot quickly
reduce, we suspect that buying puts on crude oil now and calls on industrial
stocks will be a decent positive outcome hedge, while buying leap puts on oil
sensitive, consumer sentiment sensitive, and bellwether stocks as well as
calls on short-term global interest rates will be a reasonable negative outcome
hedge. Realize though, that the cost of such insurance is currently very high —
and high levels of cash are preferred.
Meanwhile investors are not doing much buying or selling in
the markets right now. The risk premium to equities and probably all
investments is very high.
The market broke key support and could test the October
lows although the
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banks are outperforming, like our Port Financial
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PowerRating). Industrial commodity prices, which
appear likely to continue rallying upon either war outcome, are nonetheless also
getting overdone on the upside presently.
Therefore investors should keep a mix of cash in various
currencies (Everbank.com) and sit on their hands mostly, until the global
showdown develops some clarity.
Once war-jitters recede and the outlook is less risk-prone,
we believe the market will launch a strong and more sustained move — though we
don’t yet know in which direction. Watch and wait for volume, breadth,
leadership, and follow-through to emerge in one direction before allocating
serious capital to either the short or long side. Caution is still advised. It
is frustrating to be so long and so heavily on the sidelines, but that’s better
than getting chewed up in the markets in a not-very-positive market
environment. It’s better to have indicators that tell when the environment
isn’t very good.
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 39% 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.
Our official model portfolio overall allocation remains
VERY DEFENSIVE. We’re now 84% in T-bills awaiting new opportunities, with one
sole long position. Our model portfolio followed up weekly in this column was
up 41% in 1999, up 82% in 2000, up 16.5% in 2001, and up 7.58% in 2002, an
average annual gain of over 36% — all on a worst drawdown of around 12%.
We’re now off 0.91% for the year 2003.
To our daily
Top RS/EPS New Highs list the entire rally from the 7/24 and then October
lows never even registered on the radar screen having mustered up just ONE solid
week of consistent +20 or higher readings since 7/24. This past week however
our Bottom RS/EPS New Lows list DID register over 20 new lows daily, signaling
stronger breadth and directional movement on the downside once again. THE BIAS
IS NOW DOWN in the markets. We had readings of 9, 4, 3, 7, and 1 on our Top
RS/EPS New Highs list accompanied by just 1 breakout of a 4+ week range (
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which also happened to be a close call). Bottom RS/EPS New lows improved
markedly with readings last week of 29, 46, 39, 31, and 50, accompanied by 18
breakdowns of 4+ week patterns along with one close call (
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side. Selling pressure is growing and may dominate until the Iraq crisis faces
possible resolution.
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, and
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 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: Port Financial
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profits, and WebMD
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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 leadership and follow-through improve.
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 YET. Continue to watch
our NL list daily and to short any stock meeting our down-fuel criteria (see
interactive training module) breaking down out of a downward flag or down
cup-and-handle that is in a leading group to the downside 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.
A poor hunter will get bored after a few hours and start
taking long-shots at game that is not close enough to have a good chance of
making a kill. He’ll invariably not only miss his shots but also scare away any
potential game for later in the day and come up empty handed. A poor trader
will do the same thing — waste his time and effort on opportunities that have
big potential on both the upside and the downside without a clear advantage of
reliability.
The War, in my opinion, is not a reliable situation
and risks are skewed as steeply as any potential gains on either side.
I WOULD suggest that
those that have big exposure in either direction and can’t unwind it quickly do
some hedging IN BOTH DIRECTIONS as
DEFENSE. Better though is keeping lots of
cash and waiting for opportunities to improve so that reliable and good
risk/reward situations develop in a less risk-prone environment. Now is the
time to tread lightly in any avenue, as there are almost no investments that a
surprise Iraq development won’t affect.
At some point later this year, we suspect we will
get stronger evidence of clear new group leadership on the upside or downside,
substantially more breakouts or breakdowns of close-calls or stocks meeting our
criteria long or short, better and more consistent follow-through by those close
calls and criteria stocks that do breakout or breakdown, and substantially more
breadth of new highs or new lows and breakouts or breakdowns on our list.
Watch and wait for opportunities to improve. Don’t forget that profits can
come VERY QUICKLY when things all line up correctly
— like the nearly 50% gain we took from the late ’99-early 2000 three months.
But patience is required to not give our big gains back in a less than optimal
period.
Mark Boucher