Watch large-cap stocks and the bonds closely

The latest rhetoric from the Fed as well as minutes from the last FOMC meeting warn that investors have been overly optimistic with regard to how quickly rates will be cut. This along with economic evidence that the growth slowdown is proceeding only slowly have led to a correction in bonds and TLT’s. We believe investors should view this correction as ultimately leading to an opportunity to buy or add to positions, as a Fed intent on a tightening bias until inflation slows completely will likely lead to slower growth that will propel bonds higher down the road.

Big caps have done better than we expected up to now and breadth is improving somewhat on the rally, though still sub-par. We still suspect that a growth scare will eventually develop and that could lead to turbulence in even the mighty large-cap leaders of the rally since June. We would still not allocate aggressively.

Yet some large-cap allocation seems warranted here, along with bond exposure, and some pairs trades. We still like large caps over small caps which could be added to on this correction. We also continue to like pharmaceuticals and Spain over Germany.

Another leader we have mentioned in the past is Defense. This week some of the larger cap defense indexes are breaking out to new all-time highs, such as the DJ Defense Index shown below in chart 1.

A major leader in this index is (LMT | Quote | Chart | News | PowerRating), but it is quite extended and should only be bought on corrections. UTX is also breaking out today, but is not great on an earnings and value basis. Sometimes when a group displays plurality and leadership, but exhibits few or no individual issues that meet good earnings/growth/technical criteria, one should look to the i-shares or to laggards breaking out of bases.

A breakout by (PPA | Quote | Chart | News | PowerRating), particularly if it can setup a decent handle for a cup and handle breakout, would offer investors wanting exposure to this group a way in with limited risk. Chart 2 shows that PPA is also close to breaking out and bears watching.

A laggard in the group that appears on the verge of breaking out of a base is (LLL | Quote | Chart | News | PowerRating), shown in chart 3. LLL has a little bit better earnings and value than some of the other defense group, but it has still been a laggard. However a breakout of the base signaled by a high volume strong close over the 81 level might offer investors another way to gain exposure to this leading group.

We still suggest less than aggressive allocation to global equities and would look to add or accumulate TLT’s on this correction as we expect that the slowdown is not over and that the Fed will not letup on a tightening bias until the slowdown develops more clearly so that inflation does not reappear and get entrenched. We like some pairs, and some select big-cap dominated groups along with the small number of stocks meeting our criteria for below normal allocation to stocks. We have talked about pharmaceuticals and this week we took a look at defense and a couple of ways of playing this leading sector upon further technical action.

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 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.

Our US selection methods, our Top RS/EPS New Highs list published on TradingMarkets.com, had readings of 100, 47, 80, 41 and 69 with 20 breakouts of 4+ week ranges, no valid trades meeting criteria , and no close calls. This week, our bottom RS/EPS New Lows recorded readings of 3, 3, 3, 4 and 5 with 2 breakdowns of 4+ week ranges, no valid trades and no close calls. TWGP and SPI remain open trades on the long side from this methodology.

Lots of bonds and cash as well as light big-cap exposure still seems prudent to us here until the environment becomes clearer. Long/short pairs and some big-cap exposure to areas like pharmaceuticals and defense can be sparingly participated in as well. Big cap stocks have rallied on a Wall of Worry recently, but the setback in bonds may mean that wall is getting steeper ahead.

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.