Time Ticking Away As Fed Tightening Draws Near

The fed funds rate stands at 1 3/4%, well below neutral levels of 3.5% minimum. The Fed has removed its easing bias, and a tightening phase swinging rates back to neutral and perhaps beyond looms in late spring or early summer. Many foreign central banks have already started to tighten policy as it becomes clearer and clearer that a global economic recovery is underway. Fed funds futures currently discount a 75 bp hike in rates in the next six months and over 200 bp's over the next year. Expectations usually escalate on the first rate hike. 

The Fed’s aggressive stimulative policy DID successfully limit some of the downside economic damage after the tech bubble burst, but unfortunately, high valuations were preserved as a result. The developed markets therefore likely have one more chance to rally before policy begins its tightening phase and a ceiling is put on stock prices. The problem is that just as overvalued stocks did not respond well to rate cuts and the S&P has essentially been flat to lower since the Fed started its historic easing phase, overvalued stocks are also most sensitive to rate hikes very early on in the tightening phase. Excessive valuations cannot stand rate hikes. Time is ticking on this bull phase market environment – as pathetic as it has been for finding solid growth stocks breaking out of good bases.

The best performing asset class so far has been Emerging Markets. There are many reasons to suspect that EMs will remain stronger and that the bull market will remain more durable than in developed markets. EMs are still undervalued vs. their prospective growth rates and their historical mean. They have just experienced a bear market taking 70%+ in value off of them since 1994. Government and corporate policy has shifted in this long bear market to improve profitability. EM stocks in Asia and Eastern Europe are prime beneficiaries of the first phase of the business cycle, where inventory shifts and manufacturing turnaround are leveraged. EM stocks in Latin America -- where resource-dominated commodity companies are more dominant -- will be the prime beneficiaries of the second phase of the economic recovery, when commodity price strength will feed through to corporate earnings. EMs are prime beneficiaries of reflation and inflation – and any flare-up will benefit them. Portfolios are beginning a historic shift into EMs as an asset class. Aggressive investors are thus still encouraged to emphasize EMs in their portfolios until more growth stocks breakout and allow replacement.

Top RS/EPS New Highs couldn’t even manage to break the 20-per-day mark that we watch for as breakout numbers continued to deteriorate. The number of  Bottom RS/EPS New Lows this week continues to be pathetic as well, giving us few new opportunities at the moment.

Our overall allocation remains DEFENSIVE, with 76% 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 3.5% for the year 2002. We still think that our long/short strategy in growth stocks with decent value will be able to realize decent returns this year. But understand the U.S. market is likely to be volatile, and our approach will not be able to avoid some of that volatility – so expect more frequent and larger drawdowns than we’ve had so far.

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 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 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: Crown Group, now (CRMT | Quote | Chart | News | PowerRating) on conversion @8.60 (11.4) w/9 ops; Garan (GAN | Quote | Chart | News | PowerRating) @45.60 (55.1) w/48 ops; and Lands End (LE | Quote | Chart | News | PowerRating) @52 (43.34) w/42.50 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.

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 to the downside.

Again, we encourage investors to act globally and become more active in emerging markets and gradually in developed nations. The U.S. market needs to clear its resistance levels to become more bullish than we have been. This may not happen for weeks or even months and may need a catalyst such as the Fed’s announcement in May.