Market Teeters On Every Word

The market appeared to be listening very closely to a number of important announcements this week. Citing improvement in the economy, the Fed left interest rates unchanged. This news, combined with efforts from publicly traded companies to ease growing fears over financial reporting and regulation, gave the market a boost. Still, volatility is the name of the game, with volume coming in strong on both sides of the market on any given day.

A short-term reversal, while encouraging, is not a green light to jump back into the market. It is better to be patient and wait for a plurality of earnings and economic reports to confirm the positive expectations that have developed over the last quarter. Getting in too early can do real damage to a portfolio, so we will wait for confirmation. We will get excited when the major indexes rally strongly through their 200-day moving averages on an expansion in breadth.  

Economically sensitive commodities are an area to consult for confirmation that we are indeed headed for a shift in expectations toward recovery. Lumber, copper and cotton are all at various stages in the base-building process, while bonds are range-bound. We said last week that the markets would be clearly discounting imminent recovery if nearby lumber futures could move strongly above the 275 level, AND nearby copper could move strongly above the 75 level, AND nearby cotton could move strongly above the 42.50 level, AND nearby bonds fall on good volume below the 98 level.

Only one of these has occurred. Lumber gapped up through the 275 level and is now pulling back. If lumber can hold up and the others follow suit, the recovery scenario is a bit brighter. However, the recovery scenario would be in serious jeopardy if lumber falls below 215, copper below 60, cotton below 30 and bonds climb above the 105 level. Such a reversal in these markets currently appears unlikely.

We also recommend keeping an eye on commodity currencies, as they also hold clues to the health of the economy. The Aussie dollar and New Zealand dollar remain in tight ranges as they build bases; watch for the AUD to move above .55 or below .48 and the NZD for a move above .46 or below .39 to confirm the recovery/recession scenario. The Canadian dollar, another economically sensitive currency, broke to new lows last week, but quickly gapped back up into its own trading range.

For now, breadth numbers remain somewhat thin and lack clear direction. There have not been many opportunities coming across in quality stocks that are in leading sectors with favorable growth prospects. We will continue to keep the big picture in sight and take a top-down approach, paying special attention to group relative strength. This is very important in a market that may very well see a recovery that is disproportionately smaller that what we have become accustomed to.

The breadth and leadership numbers for this week are slightly more robust, but we still have not seen the sharp expansion we need in order to significantly increase allocation. Top RS/EPS New Highs stayed just above 20 every day this week (26, 21, 40, 29, 24), but breakouts were few and far between. Bottom RS/EPS New Lows accelerated throughout the week (2, 4, 4, 14, 20), but still could not push above 20 per day. Look for Top RS/EPS New Highs to not only reach 20 or higher CONSISTENTLY on a week, but also 100+ on at least one day or 50+ on two or more days before becoming very bullish.

Breakouts vs. breakdowns of four-plus-week consolidations on our lists for the week remain low, totaling 18 breakouts vs. 7 breakdowns. And most lack the volume characteristics that we like to see. There was only one close call in Action Performance (ACTN | Quote | Chart | News | PowerRating) this week, and no new trades. Remember that for long positions we are looking for breakouts in fundamentally strong companies in strong groups, and there just haven’t been many opportunities out there.

Our overall allocation remains DEFENSIVE with 84% in T-bills 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 about 1% for the year 2002.

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," course "The Science of Trading," and 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 an environment unclear directionally, we also 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: Central European Distribution (CEDC | Quote | Chart | News | PowerRating) @10.3 -- out with a nice profit at 12.42 on a 12.45 trailing ops; Ryland Group (RYL | Quote | Chart | News | PowerRating) @64.3 (79.40) w/72.30 ops; and Direct Focus (DFXI | Quote | Chart | News | PowerRating) @35.09 (35.85) w/31.5 ops. Continue to watch our NH list and buy flags or cup-and-handle breakouts in NH's meeting our up-fuel criteria -- but continue to add just two per week and only in leading groups until we get breakouts in the S&P and Dow. If two or more of our breadth criteria for the overall market develop (described in detail in previous columns), we'll drop the "two per week only" advice on longs -- but until that happens, we’ll sit tight and let the market give us more decisively bullish signals than we have seen to date.

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: NONE. 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.

We continue to advise caution and patience until the market takes a more decisive stance. We all know that the market can get ahead of itself, so it is best to wait for confirmation that we are seeing real economic recovery.