What This Market Needs

The main averages had two good-volume rally days and a decent follow-through day since last week. However, even on the biggest rally days, the breadth was nothing spectacular. Two to 1 up to down stocks on the Naz and 4 to 1 on the NYSE is not the kind of plurality of upside one would usually expect to launch a new bull move. However, this may be the start of a small upside leg that is catchable. We will need more good breadth and more Top RS/EPS New Highs with some solid breakouts in stocks that meet our criteria in top groups to exploit this potential move.

Watch and wait, and see if the market can deliver us some trades. We had some nice moves in America's Car-mart (CRMT | Quote | Chart | News | PowerRating) and Garan (GAN | Quote | Chart | News | PowerRating) since the September low. If we can get a few trades like this in any upcoming market rallies, it will be worth playing. We’ll just have to see, though, whether this current rally can materialize into anything worth investing in. We doubt it will be a barn-burner for the averages.

The EMs appear to be in a rotational correction here. Eastern Europe, China, and parts of East Asia are making new highs while the bulk of EMs correct. Eastern Europe is getting overdone and is nearing the phase where monetary tightening will have to develop, so tighten stops on these areas. China appears the best play for now, particularly red chips. Investors in EMs need to be a bit more cautious now, with the developed markets correcting. More follow-through upside in the developed markets will help end the EM correction as well.

This market continues to look like the mirror opposite of the 1998-early 2000 market. In that market the A/D declined and the broad market peaked and fell consistently. But the techs continued rallying into March 2000, when they too finally fell and played catchup in the bear move. Now we have the A/D advancing, the broad market rallying, some thin leadership doing quite well, while the techs continue to decline. Could the techs spend another one to two years groping for a bottom while the small-cap value and thin leadership sectors rally?  

Investors should watch for more indications that this rally has teeth, while keeping one eye on the ominous potential picture we talked about last week, should the broad market break below the September lows, with the S&P then completing a huge MONTHLY chart Head-and-Shoulders pattern. Watch also the nearby dollar index futures for a break below the 111 level for a weekly chart double top. The dollar bubble has mirrored the bubble in stocks – fast depreciation will spell trouble and a potential unwinding of the dollar bull move.

This week it appears that the Australian dollar (AUD) and New Zealand dollar (NZD) completed major weekly bottoming formations with valid breakouts. Sentiment is getting overdone in both currencies so that they may correct at any time, but it appears that new bull markets in these currencies are under way – a positive development for the global recovery scenario as we have been expecting. The euro (EUR) would also complete a weekly bottom on a move over 94, which would likely signal the end for the dollar. Gold would complete a huge double bottom on the monthly chart on a solid close above 340.

All of these occurring in close proximity, along with the above-mentioned breakdown in stocks, would be an ominous sign that the dollar and stock bubble are deflating rapidly and we’re headed for a more inflationary environment where assets outside of the U.S. are the main protection of capital. We don’t yet see signs that this dark scenario is developing in terms of market breadth – but investors need to keep this potential scenario in the back of their minds. Inflation would favor hard assets, other currencies, EMs, commodities, and real estate, should this develop. It’s not the odds favorite right now, but don’t miss a huge sea change if this develops. An orderly decline in the dollar will not threaten the global recovery, whereas a sharp decline will threaten and shock it.

Our odds favorite scenario continues to be a LONG trading range in developed markets, similar to the environment of 1965-1982, with intermittent mini-bull and mini-bear moves for the next 5+ years. EMs MAY be launching a secular bull market that would be much more profitable and playable. So far we don’t envision a huge new bull market in gold – but perhaps another $30-$130 move that will be quite nice for gold stocks could develop as long as the global recovery stays alive, and only until the developed world begins a tightening phase.

What the US market needs is more Ciscos – more earnings gains evidence so that earnings gains begin to take over from monetary stimulus as the fuel behind stock price gains. But so far it has been relatively profitless for U.S. companies. Is the Cisco/GE improved outlook the beginning of the earnings phase of the recovery? Possibly, but it would be much more convincing if we got some much stronger breadth numbers and rallies by market leaders not just bounces from stocks approaching old lows. Watch for breadth and leadership before anticipating any kind of real rally developing – and then only expect a potential MINI bull move

In the meantime, our US long/short strategy continues to show reasonable gains with very low risk this year. Since we have recently taken profits on our big winners in GAN and CRMT, we await fresh opportunities from any new upmove in the broad market – with or without the averages accompanying. We’re making money at a 20%+ rate so far this year. OK, but not exactly wonderful. Investors may have to adjust to a lengthy period of global multiple convergence, where overvalued U.S. stocks have trouble rallying en masse for many years, while certain sectors present limited but good opportunities such as we’ve seen in the homebuilding industry this year. And while our strategy profit is decent, it isn’t as large as those investors who have taken our suggestion and ventured into the Emerging Markets – where we suspect most of this year’s gains will be made.

Continue to monitor the commodity markets. Some commodity indexes touched old highs this week in response to temporarily higher oil prices, but the majority of commodity prices are still consolidating. Breakouts in less economically sensitive commodities, like sugar this week, may help build broader index support for a commodity rally ahead. Economically sensitive commodity indexes and markets are on the whole still positive the recovery scenario. Weakness now in copper, cotton, Lumber, and commodity currencies, accompanied by further strength in global bonds, would signal a softening in growth and a change in scenario. With breakouts this week in the NZD and AUD, this becomes less likely. Now watch for renewed new highs in Cotton, Copper and Lumber which would signal a reacceleration of the global recovery. Remember to let the plurality of markets be your guide.  

Top RS/EPS New Highs this past week were 23, 11, 8, 31, and 36 – not yet above 20 each day but improving toward the end of the week. We had one close call in OII this week, but only 8 breakouts. We need more quality leadership for this rally to take hold. Bottom RS/EPS New Lows collapsed this week with 8, 24, 13, 3, and 5 readings and only 7 breakdowns with no real close calls. Further declines in new lows at the expense of new highs next week will give credence to this rally. Right now, opportunities on both the long and short sides are scarce.

Our overall allocation remains DEFENSIVE. We’re now around 9% long and 7% short, with about 98% in T-bills (including short sale proceeds) 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 over 9.55% for the year 2002, mainly driven by a select couple of names, which is often the case in a market that is searching for leadership. Due to the volatile nature of the U.S. market, we will probably see more frequent and larger drawdowns than we’ve had so far, if we can ever get to the point of more aggressive allocation that is.

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, the course "The Science of Trading," and the 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: Garan (GAN | Quote | Chart | News | PowerRating) @45.60 –out this week on 62 ops; Land's End (LE | Quote | Chart | News | PowerRating) @52 (61.78) – now take profits on takeover; and Group 1 Automotive (GPI | Quote | Chart | News | PowerRating) @44.84 (49.71) w/ a 45 ops. 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: Mediacom Communication (MCCC | Quote | Chart | News | PowerRating) @10.54 (11.82) w/ 12 ops. 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 downside but only add up to two in any week until market weakness is more pronounced.

Traders and investors now need to stay lean, mean, and watch the broad markets like a hawk. Watch the plurality of the markets in general for clues on how to move next. Further indication of recovery will show up in commodity prices and further rallies in developed markets, giving EMs a further push. Deflationary and inflationary scenarios also need to be monitored. Now is not the time to get bored or fall asleep because of inactivity – it’s the time to watch closely the leadership and breadth numbers to determine what lies ahead and how to position to exploit it.