Watch The Global Leaders–Here’s Why
Watch the
Global Leaders
Last week we talked about late-cycle rotation starting to develop in the form of
outperformance by some health care (managed care particularly) and consumer
staple groups while tech sectors have started coming off the boil in terms of
relative performance, domestically.  Another indicator to watch that is
BEGINNING to signal this type of rotation is the Dow/Naz ratio. The ratio is
testing its long-term ’01-’04 support zone and bouncing over the downtrend line
since September, and this month the Dow is outperforming the Naz.  A further
move by this ratio above November’s highs will confirm a significant rotational
shift underway.
Many analysts are becoming concerned that the Dow’s outperformance may mark a
top in the market following an early January rally because the Dow’s performance
versus the Naz has correlated so well with upmoves and downmoves of the market
since 2000 in particular. Yet the Dow/Naz peaked in July 2002 and the Naz did
not actually bottom until October — while not really rallying with conviction
until March of 2003. And it is important to look at the WHY behind relative
moves to gain true understanding. The Dow started a bear market relative to the
rest of the market in 1998 as the “old economy†stocks did not sizzle like the
soaring “new economy†themes in the bubble years. It was not so much that Dow
stocks did better after March 2000, but that the hot tech group leaders of the
late 1990’s bull market peaked and had much further to fall. While the Naz has
outperformed since the October 2002 market cycle bottom, it has not been to
focal point of outperformance, nor a clear leader in this rally. Therefore
while the Dow/Naz ratio is important and bears close watching, we are probably
even more interested in the performance of the true leaders of this bull move
since 2002 as we are in the Dow/Naz ratio because that ratio doesn’t measure as
clearly the dynamics of leadership performance as well as it did in 2000 when
the Naz WAS the leadership.
It is USUALLY the performance of the clear leaders of a bull market that are the
best clues that a top is developing — which is why the Naz underperforming the
Dow in March of 2000 was so significant. Thus while I suggest investors monitor
the Dow/Naz ratio closely, one that might be just as critical is the ratio of
the small cap S&P600 to the large cap indices. For it is the small caps that
have been the clear leaders of the rally since 2002. Small caps had far better
value at the bottom and better prospects for sucking up accelerating growth and
benefiting from lower interest rates. Many investors may not realize this, but
small cap indexes have made new highs this year, breaking above the 2000 levels.
But there are now reasons to monitor small cap relative performance closely —
both fundamental and technical. Small caps no longer offer a valuation
advantage as they did in 2002 and 2003 — and in fact small cap PE’s/S&P’s PE’s
are at peak levels not seen since the 1996-97 top in small cap relative
performance. Small caps tend to underperform in a narrowing yield curve
environment, when growth decelerates, and when the dollar declines. Technically
the S&P 600/S&P ratio is nearing the top of a trend channel that has been in
force since 1998 and a short-term channel since August. While a top is not in,
there are enough factors coming to together that we suggest investors watch this
ratio closely as well as IJS/IWD (small cap versus large-cap value ishares) for
clues as to when the leadership (small-caps) begin to underperform and signal
clear market trouble.
We continue to like domestically managed care, transports, and staples. Growth
Europe continues to do well as a theme with countries like Ireland, Austria,
Belgium, and Hungary/Poland leading on the upside in continuation of their
strong leadership throughout this bull move. Latin America is still leading as
well, though here too, investors may want to begin watching for a slip in
relative strength compared to Asia, which is still recovering from its 2004
correction.  Bottom-line — go with the leaders whatever they may be as the bull
market may be entering its final phase.
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 had portfolios
up 17% for the year 2003) — all on worst drawdown of under 7%.  This did not
include our foreign stock recommendations that had spectacular performance in
2003.Â
This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 102, 80, 103, 111, and 129 with 24 breakouts of 4+ week ranges,
no valid trades  and close calls in NSC and JCC. Breadth is expanding again and
more close calls would be a call to add some long exposure. 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. This week,
our bottom RS/EPS New Lows recorded readings of 5, 5, 4, 5, and 1 with 2
breakdowns of a 4+ week ranges, no valid trades and no close calls. We’re
seeing a growing number of valid breakouts, though this is not a gung-ho
environment. Valid signals are in place in MLI, KMRT, GBX, and BHP. The rally
is still in place but starting to thin in breadth here, so investors should
remain aware of possible headwinds looming as discussed over the last few weeks.
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, and did not get to a fully allocated long exposure even
during the 2003 rally.
2004 has been a volatile and tricky year for investors. We suspect 2005 will be
similar — with the need for defense and nimbleness being critical to investors
success. Yet for now the bull rocks on and gives us a good holiday. Merry
Christmas to all — and a very prosperous 2005 to come!!
(Charts: New Highs and New Lows (our
charts), JCC, NSC, Dollar index, long
bond futures)