Watch For These Four Signals From the Market

September 26, 2003
Mark Boucher

Next year, elections are being held in the US, Taiwan,
India, Malaysia, Indonesia, the Philippines, Russia, and South Africa,
and politics often influence markets in election build-ups. The surge in the yen
and resulting global market hiccup this week highlights the growing threats of
political uncertainty that are likely to grow in the period ahead.

A big
question mark is how big the latest G-7 accord really is â€” and whether it is a
serious enough policy error in the works to derail the recovery. Hereâ€™s how
international finance has been working in recent years and why this is
significant. We pay foreign countries (mostly Asia) for their goods in dollars
that the Fed pretty much prints at will. But weâ€™re too big a debtor and too big
a customer for foreigners to really do much about this. Instead, they take those
dollars and buy US Treasury bonds with them, so that interest rates stay
artificially low enough that demand doesnâ€™t fall apart in the US, and so that
the dollar doesnâ€™t collapse, which it would if they didnâ€™t buy US assets with
the excess dollars.

This allows
the US economy and demand to hold up so that foreigners can keep selling us
their goods. Basically, we are buying foreign goods with money that foreigners
turn around and lend us. The result is a record high current account and trade
deficit and foreigners now own 46% of US Treasuries. For Asia, the policy helps
fight deflation and leads to stronger economic growth, masking overcapacity
problems. However, at some point, when Asian growth and inflation get strong
enough (or perhaps inflationary pressures get too strong), then foreigners will
stop buying as much US paper â€” and the dollar will slide, while the distortions
caused by this intervention will begin to unravel. As the dollar slides,
foreigners will scramble to get out of US paper and rates will rise, killing off
any recovery.

This
charade is therefore likely to continue until inflationary pressures begin to
become a problem for the major exporters to the US. However the recent G-7
accord may have sped up the end of the game. This accord put pressure on Japan
and Asia, in particular, to revalue their currencies and for global central
bankers to let the dollar slide. The question is whether the Fed will covertly
step up the pace of US bond purchases to offset the decrease in Asian purchases
â€” if they donâ€™t this, G-7 accord could be a major policy error that will cut
this recovery short. Understand that the artificial glue that is holding the
global economy together now is global acceptance of the US dollar.

Thus, one
of the potential recovery-party stoppers weâ€™ve been suggesting investors watch
closely is that of a falling dollar degenerating into a stampede out of US
Treasurys. This needs careful revisiting following the recent G-7 accord.
Slightly higher bond yields are likely to be sustainable
IF they come in reaction to an improving economy. But if higher bond
yields are the result not of a stronger economy but of a drop in the dollar,
then bond yields could abort the recovery.

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How will the markets tell us that this is happening?

A decline
in US equity prices

Widening
corporate bond spreads

Sharply
declining relative performance by cyclical stocks, and

A
widening TED spread

These four
would be a clear plurality of signals that this situation is deteriorating
enough for investors to become concerned and shift assets quickly. The initial
global bond market crash was NOT accompanied by
these other factors, and so it did not have a major impact on the stock
market. So far, these indicators are not yet signaling an end to the reflation
theme â€” but investors should watch all of these indicators closely if the dollar
decline picks up. The reflation theme deserves the benefit of the doubt as it is
the main trend â€” until a plurality of indications tell us otherwise. Yet
investors need to realize that underneath the mini-bull market in stocks and the
economic recovery is the need for the Fed to expand the money supply
aggressively to keep debts rolling to provide demand. Beneath the bull market is
an inflationary disease that will eventually grow to the point that reality
hits. How it hits will be critical to what asset classes will rise and fall in
an increasingly less stable and more volatile environment.

Our best
guess continues to be, and so far a plurality of indicators are confirming this,
that the Fed will make up the difference on any cut-backs in Japanese bond
purchases and that the pressure on China is largely a farce. It is unlikely that
the US will seriously pressure China to revalue the yuan â€” it just wants to look
like it is, to appease US manufacturers. China is more likely to revalue only
when its domestic inflationary pressures are strong enough that a gradual
revaluation of its currency will be beneficial to it â€” in other words, when it
wants to actually cool down inflationary domestic pressures now
building. However, when inflation picks up in China, it will likely have picked
up here too, and a collapsing dollar on top of inflationary pressure will be a
disaster for the bond market and the economy. How long will this take? Nobody
knows. Our guess is that it will be well into 2004, but it could be years away,
or start next week. But when it happens, watch out below! A bubble may develop
in the interim, but investors shouldnâ€™t expect the current mini-bull move to
develop into the type of long-term secular advance seen in the 80â€™s and 90â€™s.

In the
meantime, as long as the yen rally, dollar decline, and G-7 accord donâ€™t kill
the markets right here and now, the global economy continues to pick up and most
of our payroll indicators suggest that job growth is directly ahead sometime in
the next one to three quarters. As weâ€™ve been mentioning, job growth is what the
markets are waiting for to believe in the current recovery. We would therefore
not be surprised to see evidence of job growth start to materialize in the
months ahead â€” and when it does materialize, more investors will join the
bull-market bandwagon, forcing stocks higher, and the stock/bond ratio higher as
well. The sweet spot in the recovery is still likely here. That means little
noticeable inflationary pressure for a period of time.

How long is that period
of time? Typically, it is years. But because this recovery is so extremely based
on fiscal and monetary stimulus, we suspect that a mini-inflationary flare up is
much closer in time that during a normal recovery. And thatâ€™s when the fireworks
could really start to take off.

There are
other political risks besides Asian currency policy. Bushâ€™s approval rating has
now dropped below 55% and this means the odds of another person winning are
growing enough to be considered by the markets. Yet no Democrat has come up with
a platform of economic policy. There will be problems with the deficit and trade
policy that historically Democratic solutions to are not bullish for markets (or
real solutions for that matter). And how long will the public continue to fund
the Iraq War and war in Afghanistan?

Putin has a
75% approval rating now and his re-election in March is extremely
likely. Taiwanâ€™s election probably means heating up of China-Taiwan tensions
again, prior to March 2004. Chen is a closet separatist and his approval ratings
are in a free fall as the Taiwanese economy has not done well during his stay in
office. China has big political ambitions in Taiwan, and will pull out all the
stops to get a unification candidate in.

We started
emphasizing Asian, Chinese, and Thai stock funds in this column in June and
these markets have shot up an average of over 25% since then (which we donâ€™t
count in our computation of domestic equity performance). We would now take half
profits in these markets and tighten trailing stops. Shift toward broad
small-cap Emerging markets funds. We also mentioned central European funds, and
gold stocks that have soared by over 25% as well. We would not take profits
here, but we would tighten stops significantly. The move in gold is likely to be
secular. The move in Asia and central Europe is likely to be levered to the
moves in developed markets, but vulnerable to developed market setbacks, similar
to the moves in small-caps. We would now shift more toward broad EM exposure and
focus less on our favorite markets in the current environment.

Our base scenario for a global
recovery of sorts is still the highest-likelihood scenario, but there are
growing risks associated with it. While the market could easily undergo a minor
correction taking many weeks at any time, we would expect a recovery to develop
as economic news continues to confirm our base scenario and it is looking
increasingly like a much stronger growth period than markets are anticipating,
is ahead. Asia should continue to lead on the upside, although a consolidation
or correction is long overdue. Our favorite markets are now small-cap Emerging
Markets in general, metals and resources, South Africa, Eastern Europe, Chile,
India, Latin America in general, and Asia in general.

Investors should continue to
monitor the potential party killers:

Over 4.75% on 10-year
government bonds (more reprieve here);

Oil over $38-$40 (much more
reprieve here, though $25 should hold);

A fast-plummeting dollar
(watch for new highs in AUD, NZD, and CAD to announce next dollar leg down,
which seems close at hand); and

A CLEAR and strong successful
terrorist attack in the US or on a major US installation.

Gold and silver and related
stocks continue to creep ever higher, in what we suspect is the early stages of
a new secular advance. But remember these metal plays are always
VOLATILE. Also moving up nicely are base metal and
other resource plays. The CRB should continue higher before 229 is breached
after the recent breakout, as should industrial commodities in particular
(Rogers Raw Materials Fund).

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Investors should continue to cautiously add stock exposure as
trade signals are generated that meet our strict criteria, as well as allocate
to our favorite segments. 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 portfolios up over 15.5% ytd by our calculations) â€”
all on worst drawdown of under 7%.

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Last week
in our Top RS/EPS New Highs list published on TradingMarkets.com, we had
readings of 79, 74, 40, 77, and 69, accompanied by 12 breakouts of 4+ week
ranges, no valid trades and no close calls. 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. Bottom RS/EPS New Lows are
still quite weak with readings of 0, 1, 2, 1, and 3, and no breakdowns of a 4+
week range. The short-side remains bleak. Selling pressure is very low â€” the
problem is that buying power is just mediocre and starting to drop.

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.

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The new leg
up is tentative and will be nervous upon excuses to correct and consolidate. A
real policy error could derail the recovery, and the current currency debates
need to be closely watched. Yet the likelihood remains that the markets should
march higher, two steps forward and one step back as long as liquidity is
plentiful, global economic acceleration continues, and breadth holds up. But,
instead of the normal pattern of liking a market more the stronger it gets, in
this expected mini-bull move, investors should be growing more cautious as the
market rallies from here.

Mark Boucher

Watch For These Four Signals From the Market

BUY THE FEAR, SELL THE GREED

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