Watch First Breakout and Base Breakouts and Make Your Potential List

We’ve been 100% sidelined in T-bills through this incredible market meltdown and now we should look for a possible base – for either a catchable bear market rally into year-end or possibly something more. We’ve had a 90% up-day in terms of volume and breadth and minor follow-through. We need continued volume and breadth that is superior on up days than down days, a break through of some resistance (like 100 level on SPY) on good volume and breadth with a strong close, and clearer leadership in stocks close to meeting our criteria that are breaking out of bases.

One of the things we can do now is watch for leadership and what leading growth stocks are in the first group (first 2-3 weeks) of breakouts and how they are doing and what groups they are in. Scan IBD for these daily and add to our current list.

So far Base breakouts of leading IBD100 stocks already broken out in 1^st round of breakout group are: EBS (biotech), AFAM (outpatient), AMED (outpatient/nursing), STE (med systems), SWN (E&P), MMP (pipelines), STRA (Education), SRCL (pollution control), CHTT (personal care), ISYS (defense), LPHI (insurance). Groups best represented thus far are outpatient/nursing (the clear leader), education, medical systems, and pollution control. But it is very early and we must watch for all IBD 100 base breakouts and put them on our list to truly discern the type of clear leadership we need to be able to start to want to buy base breakouts that meet, or are close to meeting, our criteria.

Note that our Top RS/EPS New High and Bottom RS/EPS New Lows lists are not nearly broad enough yet to suggest a good trading market in either direction. Government policy stimulus is likely broad enough and concerted enough on a global basis to lead to a bear-rally at least – something catchable by our trading strategies. Investors should be watching first breakouts for clues and building a list of potential base breakouts in leading groups to watch – especially if breadth and volume and resistance breakthroughs in the market occur ahead.

We do remained concerned however that the policy actions might be too late to prevent a global depression. The lending freeze is thawing in some parts, but remains only partially thawed in others.

Charts 1-4 highlight the action in recent markets. The Fed continues to make substantial and positive progress on commercial paper rates (chart 1) in particular, where the lending freeze has clearly thawed. Yet interbank rates (liborOIS) and indications of risk aversion such as T-bill rates and the TED spread remain at levels that suggest many parts of the credit market are still in crisis. European interbank rates have made more progress than US ones this week. The barrage of announcements of bailouts, stimulus plans, and rate cuts on a global basis continue, and it would be hard to envision stocks not at least consolidating after such major initiatives are being announced on such a concerted global basis. However we are concerned about the action in the bond market, which declined again today (chart 2), and appears setup for another retest of the important September lows. We suspect that the fallout will grow more obvious if bonds break this critical level, but we also suspect these levels will hold. In the meantime the decline in bonds is continuing to do damage to mortgage rates (chart 3), which are now at nearly the highest levels since the crisis broke out a year ago. As we’ve said, housing cannot bottom with mortgage rates rising. Somehow the authorities will have to deal with mortgage rates eventually. Stocks still need to show better volume and breadth on up-days and to break through some resistance and show leadership in base breakouts to warrant action. Remember that by catching leaders in the first weeks following a bottom you can make more than catching the actual bottom in indexes.

 

Chart 1: Commercial paper rates heavily unfrozen in response to new Fed program this week! Crtsy Bloomberg

 

 

 

 

Chart 2: But bonds still falling and now set to test critical September low support zone ahead. Courtesy Bloomberg

Chart 3: And so mortgage rates near their highs since crisis started! Courtesy Bloomberg

Chart 4: S&P rally needs to get some volume to suggest catchable rally here. Courtesy Bloomberg

We’ve talked about what kind of volume and breadth and resistance breaking action is needed by stock indexes to signal that a catchable rally is underway. Nearly every sustainable rally in stocks off of a significant low has shown a clear pattern of rising volume with rising prices. If the market cannot get better volume support on rallies soon, it may well be signaling that only a trading range or consolidation between here and around the 1040-1100 level may be in order for some time. Our bias remains to suspect that a catchable rally is going to develop from all this stimulus and from massive oversold positions soon, but so far the technicals are falling a bit short. That can change, but technical action needs to improve further.

We have to also remain on the lookout for potholes. Macro economic reports and earnings reports are going to be negative for some time. So far authorities have done a decent job of offsetting the negative macro economic announcements with new stimulus plans in the bag and new Fed and IMF bailouts. Yet this week’s consumption release data were truly frightening and represent a major pothole we’ve talked about being hit hard. Chart 5 is a fairly ominous picture. 70% of the US economy is tied to consumption, and September’s consumption report showed that in the third quarter consumption fell much more sharply than anticipated by the consensus. This of course was before the latest market crashes were in full bloom. Since the interbank lending freeze and collapse of markets, leading consumption indicators have been in a free-fall, meaning that 4^th quarter numbers could be the worst since WWII. That hits a big part of the US economy and broadens this slowdown substantially. It will be important to see if stocks can shrug off higher unemployment and some other key macro reports ahead. If not, this bear-rally in stocks and commodities could be short-lived.

 

Chart 5: Consumption fell off a cliff last quarter and is likely to get substantially worse ahead. Courtesy Bloomberg

 

We’ve been emphasizing being fully on the sidelines in T-bills in recent columns for months, and this market environment is a good illustration of why. T-bill cash continues to look good and we suggest you patiently wait for the market to clearly signal a safer path towards taking trades ahead. We are close, but not quite there yet.

As we’ve noted, it is not stocks but the credit system that is now the epicenter of this crisis. Interbank lending remains in crisis mode – it has improved, but the progress is slow and damage is growing as long as lending remains partially hindered. Will current stimulus plans be too little too late and lead to serial 1-2 quarter stock rallies and economic improvements that then deteriorate over time? We will have to watch market action for indications ahead and keep this possibility in mind.

 

Our long/short strategy remains happily 100% in T-bills awaiting new trades. Since our last update we got neither close calls on the buy side or on the short-side. Now our lists are starting to grow slowly from the depths again. Check out www.midasresourcegroup.com for daily listings of Top EPS/RS New Highs and Bottom EPS/RS New Lows to make sure you catch all potential breakouts meeting our criteria. As the chart at the bottom of the page illustrates, we don’t have enough Top RS/EPS New Highs or Bottom RS/EPS New lows to start trading on either side just yet. As we’ve been saying for months and recent action is clearly proving out, this is often the most dangerous, volatile, and tricky phase of a bear market and we suggest the sidelines heavily.

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 “upfuel," 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 www.midasresourcegroup.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. We then continue to buy new long 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). We keep capital in T-bill cash while waiting for more trades. We have been 100% cash for some time now, and very glad of it in this incredibly dangerous and volatile market period.

The chart below shows that neither Bottom EPS/RS New Lows or Top RS/EPS New highs are more than 40 over the other (available on www.midasresourcegroup.com), and so the environment is not yet ripe for good trading opportunities short or long by this methodology. Remember not even surfers try to ride hurricane waves! Heavy cash T-bill defense remains warranted as opportunities build. These are historic markets and your goal should be to survive them until the panic subsides. Government action can blindside even the best trader in these environments, which is why so many top hedge funds are getting killed here. This methodology did not get hurt during this historic market meltdown, and has instead held onto its gains from earlier in the year by playing defense in the extreme in this crash.