The Dow tests record highs

The Dow Jones Industrial Average is flirting with its 2000 highs and this has attracted lots of media attention. The S&P remains 16% under its 2000 highs and the NASDAQ would have to double to reach its 2000 levels. The market as a whole is not up to the levels of 2000, but big-cap stocks are, and many important big-cap indexes have long ago surpassed 2000 levels (Dow Transports and NYSE index for example).

We remain more enthusiastic about bonds (TLT | Quote | Chart | News | PowerRating) than stocks on the whole going into a slowdown that it is not clear how steep will be. Bonds are performing about on par with big-cap indexes and offer lower risk, though they are overdone on the upside in the short-term. And we remain not wildly enthusiastic about anything here. Market breadth is also sub-standard for a sustained advance. The broad market represented by the Value Line Index has only retraced about 60% of the decline since May, and small cap indexes have not yet reached a 50% retracement, while the big-cap indexes approach May’s highs. In addition cyclical stocks, emerging markets, and commodities equities are in a defensive mode.

Oil has declined sharply, bonds have rallied nicely, and growth has started to slow meaningfully. Bonds and oil are providing a nice cushion under the impact of the slowdown to big-caps so far. They may continue through throughout the slowdown, and big caps may be able to move slowly and erratically higher through what we suspect is a soft-landing developing. However housing indicators have dropped sharply enough that in the past has always triggered a recession. The big key to whether a soft-landing or recession lies ahead is the consumer. If the housing crunch leads to a big decline in consumption, a recession is quite likely. So far it is mainly residential housing that is weak. Payrolls remain resilient as do corporate balance sheets, capital investment, and non-residential construction. Our models show a soft-landing as the most likely scenario. Yet there appears to be enough weakness in leading indicators and housing that growth scare may materialize in the period ahead. And a growth scare and fear of a hard landing normally entails a period when even big-caps are impacted by the slowdown, while bonds continue to rally. Therefore bonds, which are matching the gains in big cap indexes, remain a safer and surer bet than big caps to our mind, and in our models. The SAFER buying opportunity for stocks is normally during the growth scare. We suggest patience and conservative allocation. Some allocation to pharmaceuticals and long/short pairs may be warranted, but be careful and keep most of your powder dry.

Certainly we stand ready to go with the up move in big caps IF breadth and internal strength picks up. But so far that is not happening with enough plurality to force a suggestion of strong allocation. Internal breadth is improving some, but is still below levels normally associated with a sustainable bull market move. We continue to rate the macro environment as not highly reliable (except perhaps for bonds and TLT, which are likely to beat cash as the US slows down and have broken out of a base recently). Investors should continue to skeptically let market action be the guide. Strong rallies in the major averages accompanied by high volume to create a couple more follow-through days would be the first sign of more upside ahead. The real excitement may not come until the breadth of Top RS new highs starts to expand broadly and stocks meeting our runaway up fuel criteria begin to break out with some plurality. Until then, we still suggest caution. We have had a few close calls in our criteria that investors could participate in with less than normal allocation, such as (TWGP | Quote | Chart | News | PowerRating) last week. Nonetheless for investors, we continue to regard this as a TREACHEROUS ENVIRONMENT where CAPITAL PRESERVATION SHOULD BE PARAMOUNT. Don’t allocate heavily to anything that doesn’t scream at you.

This difficult market environment should not come as a surprise to our readers. In late March we began writing about the danger of the current market environment and how in 2006 the macro big picture would likely SWAMP all trading strategies and that not understanding the precarious position the world was in would be a detriment to traders. We don’t believe that the decline after May was the end of this scenario.

We believe it will be more important than ever to keep abreast of the global macro environment. I wouldn’t want to trade in any timeframe without a full understanding of the current dangerous macro environment and how the recent decline could be just the tip of the iceberg IF certain developments transpire from here.

Our US selection methods, our Top RS/EPS New Highs list published on TradingMarkets.com, had readings of 28, 8, 19, 51 and 51 with 19 breakouts of 4+ week ranges, 1 valid trades meeting criteria (SPI | Quote | Chart | News | PowerRating), and no close calls. This week, our bottom RS/EPS New Lows recorded readings of 6, 14, 16, 8 and 1 with 4 breakdowns of 4+ week ranges, no valid trades and no close calls. The “model” portfolio of trades meeting criteria has some time back exited all positions and is heavily in cash.

Lots of bonds and cash seem prudent here until the environment becomes clearer. Long/short pairs and some big-cap exposure to areas like pharmaceuticals can be sparingly participated in as well.

Mark Boucher has been ranked #1 by Nelson's World's Best Money Managers for his 5-year compounded annual rate of return of 26.6%.

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". His website is www.midasresourcegroup.com.