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Jeff Saut Presents: You Did Not Stutter


...while this current "throwback rally" in the U.S. equity markets has been impressive and may last another few sessions, i am worried about the subsequent downside retest.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"You did not stutter . . ."

. . . A comment from a Boston-based portfolio manager!

Last Monday I was on the Nightly Business Report (NPR), again on Tuesday morning I did CNBC. On both of those venues I stated a "trading low" was likely at hand that would hopefully begin the bottoming sequence seen at most of the tradable "lows" of the past five years. That sequence typically begins with a trading low, followed by a sharp "throwback rally," and then a subsequent pullback to those recent trading lows for a successful retest before the bottoming sequence is complete. And "You did not stutter," was the comment from one portfolio manager shortly after our interview where I flatly stated that a "trading low" was at hand and recommended a scale-in buying approach for "trading positions" using the various indexes. That strategy was reprised repeatedly in our comments last week where we recommended buying a one-third trading position on Tuesday, another one-third position on Wednesday, and the final one-third on Thursday. While we recommended buying the first two tranches on Tuesday and Wednesday's opening prices, we did not "buy" the final one-third position due to Wednesday's outsized rally (DJIA +110 points). Plainly, our "buy 'em" recommendation has played in spades even though we "flinched" on the final tranche of our buying program during Thursday's upside explosion, refusing to "pay up" for a complete "trifecta."

Unsurprisingly, the stocks/indices that declined the most from their May highs had the biggest percentage rallies from last week's lows. For example, the iShares MSCI Emerging Markets Index (EEM) fell 27% from its May high before reversing last Tuesday and rallying 9.8%. And because of the vigor of last Wednesday's, as well as Thursday's, rallies, we suggested selling half of the trading positions into any "Friday Strength" to give the other half of said trading positions the "cash cushion" necessary to not lose much money in case the anticipated downside retest of last week's lows proves to be unsuccessful (read: lower lows). Indeed, while we are hopeful, we are not convinced that last week's lows will "hold up" on any subsequent retest given the technical damage that has been done to ALL of the world's markets. Indeed, the "global gotcha" saw most of the world's indexes break below their respective 200-day moving averages (DMAs). Moreover, all of the international indices we monitor turned down simultaneously some six weeks ago! In the past, when this has occurred, it spelled trouble for our equity markets for at least the next four to five months.

Manifestly, when the markets decline the way they have over the last six weeks, it is unknowable (at first) if it is just a correction or something worse. As Michael Santoli scribed in his Barron's column over the weekend:

"Andrew Burkly, technical analyst at Brown Brothers Harriman, produced a packet of charts of 14 cyclical bear markets dating to 1948, to show that the first leg lower always appears to be a textbook correction. The initial decline tends to average 5% to 10%, with many clustering around the 8% drop from recent high to last week's low, before spilling further before long. Burkly has already been on record as predicting a bear phase that would take the S & P 500 down a total of 15%, peak to trough."

Consequently, the question now becomes, "Was this just a correction, or have we spilled over into a 15% to 20% cyclical bear market?!" To answer that question it is worth noting that the downside selling stampede ended on the 24th day of the envisioned 17- to 25-session selling-skein. That decline produced two 90% downside days, three 80% downside days, and three 80% upside days. Such days are defined as when points lost, or gained, exceed 80% or 90% of total points, accompanied by 80% or 90% of the volume being either on the downside (downside days) or the upside. Historically, such selling pressure, as witnessed during the recent decline, is followed by a sharp "throwback" rally lasting two to seven sessions before a downside retest of the recent lows. And that retest of the "lows" determines if this is just a correction, or something worse. The key "tell" is if those lows hold, or if they are decisively broken to the downside. Of course at this point, it is unknowable if the upcoming downside retest will be successful, which is why we recommended selling one-half of our trading positions last Friday. If the rally resumes this week, we will be raising the stop-loss points on the balance of our trading positions. If, however, we saw the entire throwback rally last Wednesday and Thursday, then the profits we "booked" on Friday should give us the cash cushion to hold the balance of our trading positions to see if the retest will be successful without losing much money.

Regrettably, between now and the envisioned downside retest, the environment is likely to be pretty difficult! Accordingly, we continue to ready our "Buy Lists." For mutual fund investors, we have repeatedly suggested those funds that can play the markets both "long and short." For the past few years we have embraced the Quaker Strategic Growth Fund (QUAGX), managed by the brilliant Manu Daftry. Yet there are other long/short funds, like Diamond Hills Long Short Fund (DIAMX) and Icon Long Short Fund (IOLCX), both of which are up roughly 5% year-to-date.

The call for this week: Sometimes the Point & Figure Charts (P & F) provide a "strikingly" different perspective of the world's equity markets than the vertical bar-charts do. Therefore, over the weekend, we perused many of the major-market indices using the P & F Charts. And except for the D-J Utility Index (DUX), most of the world's indices are negatively configured, having broken down from what looks to be massive topping formations. Consequently, while this current "throwback rally" in the U.S. equity markets has been impressive and may last another few sessions, we are worried about the subsequent downside retest . . . and continue to defensively position accounts accordingly.


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