Why I’m playing defense

• October 28, 2005
• Mark Boucher

Global bonds broke down further this week, and
sharp breaks below this week’s lows in US bonds
(
TLT |
Quote |
Chart |
News |
PowerRating)) and global bonds may
weigh on global equity markets further.  We still believe that bonds are going
to need to behave better before any sustainable new bull leg up in global
equities can embark.  Further downside in global bonds could also make things a
bit ugly for global equities and bear close watching.  Bonds acted as a safety
net against global equity declines since 2002.  That is no longer the case and
our concern rises until it is again the case.  Investors should be mostly
watching the gyrations from the sidelines in this environment in our opinion,
even aggressive traders.  Many indexes and sectors are in vexing trading ranges
that can be a minefield for speculators and test the patience of investors.

It is always valuable though to
watch what is showing relative strength and holding up well, versus what is weak
and leading on the downside, looking for a combination of technicals,
macro-variables, and fundamentals for a higher odds situation.  So far it
appears that Japan, gold, transports, and insurance are holding up fairly well. 
On the weak side are Consumer Discretionary, US Housing, Italy, and India. 
There may be some pair opportunities for aggressive investors only, and with
much smaller than normal allocation, in this analysis.

The Housing Index has broken
down and continues to weaken.  REITS however has held so far at 200 ma support. 
There has neither been a strong volume rally off of this level nor a breakdown
below it, so investors should continue to monitor this as a signal.  Ditto for
QQQQ’s which have bounced off of 200 ma support, but not with vigor.   RTH is
ranging between around 90-95 and a good volume close above or below this range
should indicate at least the next short-term move, with a decline under 85
continuing to be significant on the downside potentially.  BKX index
(
BKX |
Quote |
Chart |
News |
PowerRating)
has been surprisingly resilient but is now testing its 200 ma from underneath,
and shows neither definitive bullish or bearish action. 

The dollar also seems
range-bound between 88 and 91.  Current political scandals are wreaking some
havoc on the dollar, but not quite yet definitively.  A weaker dollar would be
likely positive for the market and for gold.  We suspect that until the markets
begin to discount an end to Fed rate hikes, a substantial dollar decline will be
difficult. 

Oil prices broke down through
and head and shoulder top recently and are in a short-term downtrend channel
that may not find support until the 200 ma is tested in the 57-58 range —
although a breakout through the downtrend line must be viewed as positive for
oil prices if it occurs.  Investors should however monitor whether positive oil
prices filter into oil stocks.  XLE has tested its 200 ma and is stuck in a
range between 51 and 45 or so. 

For now we continue to advise
caution and very low allocation even to hedged portfolios and even for
aggressive traders.  It’s watch and wait for better odds time here in our
opinion.

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. 

This week in our Top RS/EPS New Highs list published on TradingMarkets.com, we
had readings of 35, 34, 66, 50, and 55 with 32 breakouts of 4+ week ranges, no
valid trades and one close call in VIGN.  This week, our bottom RS/EPS New Lows
recorded readings of 48, 35, 21, 27, and 29 with 6 breakdowns of 4+ week ranges,
no valid trades and no close calls.  The “model” portfolio of trades meeting
criteria are now short NDN and SUP.  The environment is getting trickier and
more treacherous and we are chickens when it comes to risking principle unless
it looks like the weather is clear.

For those not familiar with our long/short strategies, we suggest you review my
book

The Hedge Fund Edge. 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.

We continue to advocate mostly Defense here.  Let’s watch the fireworks from the
sidelines for bit.  Remember that one of the biggest keys to keeping equity
market drawdowns low is to know when the odds are NOT in your favor and the
risk/reward is not so strong.  That unfortunately continues to be how it looks
to us now.

Mark Boucher