Gue: A Case for Caution

08/22/2003 12:00 am EST


Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Elliott Gue serves as editor of Wall Street Winners and Trading Floor Pro. He also oversees the Advantage Portfolio in Personal Finance, which is the most aggressive portfolio in that newsletter. Here, he discusses his cautious near-term view on the market, and offers some bearish trading suggestions.

"You don't have to be afraid of trading. Most people have this image that trading involves sitting at a screen all day, pressing buttons and getting in and out of things within the course of one day. That's not necessarily the truth at all. What trading does is to allow you to profit from both rising and falling markets. You can short sell stocks, by borrowing shares from your broker, and basically try to profit from a stock going down instead of up. This kind of strategy has worked very well over the past couple of years as the market averages were heading lower. We feel that we've moved out of a climate that persisted for much of the 1990s and moved into more of a broad trading range in the major. This makes it a golden age for traders in many respects.

"In the 1990s--with the Dow and the S&P returning on average 15% to 17% a year--there really wasn't any reason to actively trade a portfolio. You could be content holding a broad-based blue chip mutual fund. But when trading really does shine is when the market trades up and down in a cyclical fashion, when you can profit from swings in both directions--whereas over a long period of time, the major indices may return next to nothing. After the 1929 crash, it took decades for the Dow to re-take its 1929 high. For most of this period, the market essential traded sideways.

"Another example is Japan. The Nikkei topped out at close to 40,000; it cracked in 1992, and basically traded sideways for a decade. I think we are entering a period just like that. We are coming to a period where the major averages may do next to nothing for a long time as we move through and remove the excesses that we had in the bubble period. Therefore, you can't expect to get strong returns just from holding a basket of stocks. On the other hand, you can certainly profit from the ups and down in the major averages.

"As for right now, we've had a pretty impressive rally off the March lows, where everything has moved up at the same time--bonds, gold, income stocks, growth stocks, tech stock, non-tech stocks. However, we've reached a point where the next two to three months are generally very negative months for the market. In addition, money managers already have huge gains built up from this rally off the March lows; they've pretty much made their year in terms of their expected returns, and they are going to be looking to lock in those gains. Over the next two months, we'll probably see the market retreat. So in terms of looking at the market right now--apart from the seasonality effect--there are signs that a top is in progress.

"Technically, tops take a lot longer to form than bottoms. If you think back a year ago, to July 2002, the market was in a waterfall sell-off. We then had a pretty good rally in August. That's a typical bottom formation with a panic, a quick dip down, and then a sharp rally--a V-shaped bottom. With tops, you generally have a period where stocks are distributed over a month or two before really starting to sell off. I think that is what we are seeing now, as the market is gradually starting to roll over. The S&P actually topped out in June, it's retested that high, and it really hasn't made much progress. If you look at the volume figures over the last month and a half, you'll notice that on days when the market has been down, volume has been a lot higher than on the days when the market was up.

"Volume figures tell us that institutional players--who really move the market and really influence most stocks--are gradually selling out of their holdings and using this rally as an opportunity to sell into strength and get out. We're starting to see that distribution hit the market now. We also to look at the actual positions of futures traders in Chicago. The Commodity Futures Trading Commission publishes a report each week detailing the positions of commercial traders--the big players in the futures market. Are they long or short? They have been remarkably accurate over the last several years. During February, March, and April of 2000, they went from being extremely net long to net short futures. Sure enough the market topped out and has been heading down ever since. They've also remarkably timed some of the recent bounces. They went net long in late September of last year and caught most of the rally through December. They went net long again in February and March of this year, right when the war was getting going. If you look at their positions now, they have just gone massively net short. As a result, we're looking for a pretty impressive pullback in the market over the next month or two."

Here are some of Gue's latest short-term bearish bets from his Trading Floor Pro newsletter:

"We recommend that traders buy puts on Continental Airlines (CAL NYSE). We suggest the December 12.50 puts at prices below $2.50 per contract. We're allocating $2,500 out of our model portfolio of $50,000 to this trade. After a nice run-up earlier this year and some signs of improving business conditions this summer, airlines have priced in a lot of good news. The recent rollover in Continental has taken the stock back below its 50-day moving average, and a pullback to 9.15 is the most likely scenario.

"We also hold puts on Capital One (COF NYSE). We suggest the December 45 puts. The stock recently rose on an upgrade from Wachovia Securities. This looks like a lot of panic buying and some short covering. The stock has key resistance in the 51 area, where we expect sellers are happy to unload because of Capital One's history of spotty performance and rather extended nature of its stock. We currently expect to hold this position for a couple of months--that's why we're using December options.

"We also recommend a short position in Centex (CTX NYSE) at prices above 74, setting a stop at 79.27. Originally we recommended a short position in the stock of $2,500 based on our hypothetical model portfolio of $50,000. We're now recommending you bump that position up to a full $5,000. Our eventual downside target is about 60 for the stock."



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