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Market Notes: Q4 2005

Welcome back to Sitka Pacific. We had a good 3rd quarter at Sitka Pacific, and I hope you had a good quarter as well.

Although the S&P 500 and was flat, the Dow was flat, and the NDX gained slightly over the past three months, some areas of the market made significant advances, and others broke down decisively - likely ending their bull markets from 2002-2003. In the sections below, we will focus on two domestic sectors in particular that made decisive breaks in Q3: Gold and Homebuilding. We will then profile a market outside the US that made a decisive break to the upside and has presented us with a fresh new bull market: the Nikkei in Japan. In this edition of Market Notes we'll examine these events in detail and skip over some of the routine updates.

  • Our Portfolio Performance for Q3
  • Stock Market Overview
  • The Breakdown of the Homebuilders
  • Gold in Dollars, Euros, Francs and Yen
  • The HUI Breakout
  • The Nikkei and the Yen

Portfolio Performance

Our two main portfolios showed gains in the 3rd quarter, despite the endless churning of the S&P 500. In such times, even though the main indexes make little headway in either direction, there are often many individual sectors and stocks making significant moves up and down, and this was certainly the case over the past 3 months. We remained relatively cautious throughout Q3, with high cash levels, a heavier weighting towards short positions, and full use of options strategies to reduce risk.

The return of our long-short portfolio in the 3rd quarter reflects the profitable spread between long and short positions, as well as gains in speculative positions: accounts managed by our Hedged Growth Portfolio gained 8% on average from July through September.

Accounts managed by our long-only High-Yield Growth portfolio gained over the quarter even though high-yield stocks as a whole performed relatively poorly. Gains in Gold-related shares and a select few foreign ETFs and closed-end funds made up the difference: accounts managed by our High-Yield Growth portfolio gained 3% on average from July through September.

Not surprisingly, the most profitable long positions we carried throughout the quarter were in energy and other sectors effected by the hurricanes in the Gulf. Examples of a few of the long positions we held in Q3 are BMHC, CMCO, CNX, FTO, SWN, and VLO. Of course not all of our long positions did well, and a few of these include KBH, LCAV, and LSI.   

As was mentioned above, high-yield stocks did relatively poorly. Bond yields also trended higher, which added to the general trend of rising yields in Q3 - a drag on these stocks. However, one of the best performing high-yield stocks we held this quarter was FDG, which rallied from $90 to above $140 before a 3-for1 stock split. Another position that performed well in Q3 was MO. On the other hand, one of our poorest performing positions was FBR, which fell around 30% from our entry. This would have been a straight 30% loss for this position, but our option hedge reduced our loss to less than half of that.

On the short side, there we some very profitable positions in Q3 - as there usually is this time of year. Examples of some of our profitable short positions over the quarter include ENZN, NPSP, SEAC, SRT, and VOL. A few examples of short positions that did not do as well for us are KEYS and LMS.

The S&P 500 may not have gone anywhere over the past few months, but there was a lot of movement within the index and within the market as a whole. That is the kind of environment in which a long-short portfolio can do quite well if composed of the right stocks - which is what our methods specialize in.

Our speculative positions, which include positions selected outside of our stock models, did well in Q3 as well, which added to the returns of all our accounts over the past 3 months. Some of the research that went into those speculative positions is detailed below, along with thoughts on markets and opportunities that are currently being examined for future positions.

Stock Market Overview

When we last looked the S&P 500 three months ago, it was trading around 1200 and had been showing deteriorating internal technical signs. After drifting higher through July and August, the cracks finally started to show in September. And as of the first week of October, the S&P 500 is again trading around 1200 - making the 3rd quarter a wash.

Even though it may seem like the market is just meandering in the hinterlands, one look at the Weekly chart gives us much needed clarity.

The high in early August at 1245.9 was only 7 points below the 61.8% retrace of the Bear market of 2000-2002. This level is significant because the S&P 500 has responded strongly to retrace levels of the 2000-2002 decline, which strongly suggests this rally from the low in 2002 is a correction. The first rally from the low in October 2002 at 768 made a high at 954 in early December 2002, which is an exact Fibonacci 23.7% retrace. The rally from the March 2003 low paused at the 38.6% retrace at 1068 before making a sprint to the 50% retrace at 1160. Now the S&P has hit (for all practical purposes) the 61.8% retrace at 1253.

The Weekly MACD shows the declining momentum on the approach to 1253 by making lower highs in early 2005 and now in late 2005, and is now pointing down. The Weekly ADX has now crossed over into Sell territory, and along with the negative MACD gives a decidedly negative outlook for the market. A look at the Daily chart will show us where the lines in the sand are.

The Daily chart shows the S&P has not just been randomly bouncing higher, it has traced out a rising wedge that appears to have begun in December 2003. As of Friday's close, the S&P is sitting right on the lower trendline after briefly breaking below it earlier in the week.

A break below this trendline would likely lead to a resumption of the Bear market, and may bring about a dangerous 4th quarter. Initial targets are 1140 and 1100, but it is important to emphasize that a break out of this wedge after hitting the 61.8% retrace would likely indicate a large-degree trend change that would lead to much lower stock prices. The ultimate low may be many quarters away, and could possibly be many hundreds of S&P points lower. It would be no time to look for a bottom - it would be time to Bear-proof your portfolio.

On the other hand, if the trendline holds the S&P could easily make another run at 1253 over the next quarter. Despite the bearish technical picture, we must remember that the goal of a Bear market is to ring as much speculative money out of the market as possible - and that includes short money. If the trendline holds, the market will likely head up to 1253 or higher.

We are lucky to have such a clear picture of the market in these charts, and even though that picture always changes as we get more information, the lines are quite clear at the moment. If the market starts to head down, it will pay to at least shift your portfolio to a cautious allocation towards stocks. In our managed accounts, we use options to hedge price action on individual positions when the market is giving warning signs, and sometimes the effects of price action are removed entirely. Depending on how the market acts in the next few months, a hedged approach may prove most profitable.

The Breakdown of Homebuilders

While the S&P has yet to decide whether to break down or not, Homebuilders, as represented by the Philadelphia Housing Index, made their decision just last week. The Weekly chart below shows the uptrend line from 2003, and the break below it all the way to the right:

Throughout 2003 and 2004, there was an exponential increase in the number to top calls for housing and homebuilders. However, it has been eerily quiet in 2005 - it seems that homebuilders may have rallied far enough to have run the last bears out of the pool.

The trendline break indicates 2005 may have indeed been the end of the housing bull market, and it comes at a time when insiders have been selling record amounts of stock and pundits have been all the more adamant that there is no housing bubble. We all choose who we listen to, and we can choose to listen to people who have a vested interest in convincing others to keep on buying (even though they may take actions with their personal assets contrary to their bullish proclamations), or we can listen to the objective conclusions given to us by the charts.

The trendline break tells us it is highly likely that the bull market from 2003 is over and the trend for Homebuilders is down or sideways. Those holding these stocks should protect themselves.

Gold in Dollars, Euros, Francs and Yen

From last quarter's Market Notes:

It is notable that Gold has begun to break out in other currencies besides the Dollar. Below is a chart of Gold priced in Euros. During Gold's rally in Dollars over the past 4 years, it has remained range-bound in Euros until last Quarter. If we see Gold breaking down out of its uptrend in Dollars relatively soon, then Gold's breakout in Euros will seem to be more of a currency move. However, if we see Gold start to rally in other currencies along with the Dollar, it would suggest Gold has until now been in the early stages of a much deeper bull market that is shifting gears. Given that Gold is barely in the public's consciousness, those who recognize these potential signs early will be in a good position.

Over the past 3 months, Gold's breakout in Euros, Francs and Yen has cemented itself. Gold has also started another move higher in Dollars, even as the Dollar has continued to rally against most other major currencies. Gold is clearly entered a new phase in its Bull market, advancing in all major currencies in tandem.

As public consciousness of Gold grows, there will be very nice returns for those who were aware of the trend beforehand. There are countless arguments for and against gold on a fundamental basis, and we do not yet know what exactly is driving this bull market. The underlying reasons for a bull market are rarely clear until after most of the gains have been made, so don't be paralyzed if your aren't sure about where the economy is going. One of the advantages of seeing early trends emerge in the charts is that we do not have to know the answers to all the fundamental questions in order to take our positions, and we know early on when the trend has likely ended.

Below are charts showing Gold in Dollars, Euros, Francs and Yen. Take a look at these, and then we'll look closely at the HUI.

The HUI Breakout

Before we get into the HUI charts, a note about Elliott Wave. At its most basic level, Elliott Wave analysis is about distinguishing moves that are with the larger trend from moves that are against the larger trend. That is it - all the rest is really of secondary importance. There are many difference sects of EW, which have their own unique rules of labeling, but they are all trying to do the same thing - determine the direction of the larger trend.

When EW analysis is kept at this base level, it can be very useful. When its conclusions are taken out of context, or they are presented in a deterministic way instead of a set or probabilities, EW can be very misleading. There are never any guarantees in the stock market, and the same applies to EW analysis and conclusions. However, when it is used properly EW can be a powerful tool to nail down the likelihood of potential market actions.

Having said all that, the HUI Gold Bugs index shows one of the clearest EW impulse/correction patterns out there. The Weekly chart below shows the HUI from its low in late 2000. From that low through the high at 258 in December 2003, you can see 5 clear waves (labeled 1-5 on the chart). From the high in December 2003, you can see a clear 3 wave correction (labeled A-B-C) that made two lows near the Fibonacci 38.2% retrace.

This is as close to an ideal EW form as you will probably ever see on this large time scale, and it is certainly the clearest pattern out there right now. Let's go over what this chart tells us, and perhaps more importantly, what it does not tell us:

  1. The bull market from late 2000 through December 2003 was most likely the first move in a larger uptrend. It is highly likely that at some point in the future the HUI will trade much higher than 258.

  2. The corrective pattern from December 2003 adds considerable weight to the likelihood that at some point in the future the HUI will eventually trade much higher than 258.

  3. It is entirely possible that the HUI could have much more downside to go in this correction from December 2003. This could either manifest itself in a continued sideways consolidation between 260 and 160, or it could involve a more severe decline down to one of the lower retrace levels below 160.

Bottom line: A strict interpretation of EW suggests that the HUI will eventually trade much higher than 258, but does not rule out a trip to 120 (or lower) between now and then.

Does that leave you satisfied? Well, it's good we have more to look at than a weekly chart. A weekly chart is a long-term chart that gives us the long-term trend. If we want to know more about the short-term trend, we will have to look at a more short-term chart. Below is a Daily chart that shows the corrective consolidation from December 2003 through Friday's close:

This chart shows the A-B-C decline from December 2003, and this tells us that the very long-term trend remains up. It does not tell us that the HUI is now guaranteed to rally up to 500 or a 1000 in a wave 3, as some would claim - although that is one potential path. It does tell us that long-term investors now have a bull market to scale into, if you haven't already. If your time horizon is more than several years, and you have the patience and the discipline to use any additional weakness as a buying opportunity, then precious metal shares may be one of the better investment opportunities in the US today.

For those of us who would not want to hold these stocks for a return trip to 120 on the HUI, the most important feature of the above chart is that the HUI is trading above the downtrend line from the high in December 2003, which is currently around 230. It broke above this trendline in August and has consolidated. Based on the structure of that consolidation in more short-term charts than the Daily, it looks as if the HUI is preparing to advance again beyond the recent high at 250. Of course, that doesn't rule out weakness in the very short-term (over the next week or two), but the potential is there. The HUI needs to remain above this downtrend line on a weekly basis to keep this uptrend intact.

On the whole, the HUI looks quite positive both over the long-term and in the short-term, and our accounts are currently holding a number of these and related stocks. We are not married to these positions however, and will exit them if the market action suggests the odds are not in our favor over the next few months. Over the past 6 months, Gold has been advancing while the Dollar has been rallying against most other major currencies - but that appears ready to change as the Dollar looks ready to decline against most major currencies over the next quarter. We will see how Gold reacts with a Dollar wind at its back.

To close out this look at the HUI, there is the chart below which shows a fractal relationship between the last 5 years and the 1 st year of this bull market. These relationships are purely anecdotal, and do not give us anything concrete to trade off of, but it is interesting to see them pop up throughout the market universe.

The Nikkei and the Yen

While the S&P 500 is precariously hanging on to its uptrend, the Nikkei has broken out of its 1 ½ year consolidation with a vengeance. After the break above resistance at 12,000 in August, the Nikkei quickly sprinted up to 13,783 as of last week. It now appears that a correction of some or all of those gains may be underway, but the Nikkei remains in a bullish long-term trend. Here is a Weekly chart.

It is possible that the low in mid-2003 was a long-term low, and that the Nikkei has ended its Bear market from its 1989 high. If so, this advance will likely show certain characteristics that would give us confidence that the very long-term trend is now up. So far the Nikkei has not responded to Fibonacci retrace levels of the 2000-2003 decline from 20,833 to 7603. This is a bullish sign. There are other bullish signs as well, for instance property prices in Japan have begun to rise for the first time is over 13 years. If Japan's long bout of deflation is coming to an end, the Nikkei will be a direct and immediate beneficiary.

Over the past year, investing in Japan has been somewhat hampered by a falling Yen versus the Dollar. However, that trend may be mature and ripe for a change. If so, that will give added strength to Japan funds.

Like Gold stocks, our accounts are positioned in Japan but we are not married to the long-term view presented in the Weekly Nikkei chart above. If the Nikkei shows signs that a larger move down is developing, we will exit. With any luck, we won't have to for some time.

Have a Good Q4

There are many opportunities out there right now, both on the long side and the short side. We will be busy investing based on our portfolio models and hedging to protect our client's capital when it's appropriate, while taking advantage of opportunities like those outlined above. With any luck, Q4 will be a profitable one for all of us.

Charts courtesy of StockCharts and Saxo Bank.

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