Playing the Pullback in Red-Hot Canadian Small-Caps

North American markets plunged yesterday morning only to recover by the end of the day. Now the futures look abysmal (again!) What the heck is going on?

Many people (including my friend and currency expert, Jack Crooks) say it's the unwinding of the yen/US dollar "carry trade." A carry trade occurs when a speculator borrows in one currency and trades in another. Few markets have been riper for carry traders than Japan, thanks to the two-decades of recession which in turn made the Bank of Japan (BOJ) institute near-zero borrowing costs in an effort to get people to borrow money and put it to work in the economy.

Many large investors have taken advantage of the free money to borrow hundreds of billions of yen at 0.25% and invest that money in US Treasuries paying 4.5%. But they also invest the money in US stocks, too. Hey, it's "practically free" money. Why not?

But note the quotes I put around practically free. Money is never truly free. It always comes at cost to someone.

Anyway, the carry trade tends to make investors rich in a bull market. So long as rates are cheap and the spread between the rates is large, this results in higher liquidity, increased demand for equities and higher stock prices worldwide.

Still, it's a delicate balance. The BOJ raised its prime rate to 0.5%. What's more, the BOJ is making noises that those rates may continue to rise. Investors doing the carry trade start to price in that risk. They scale back on their carry trade investments. This reverses the tide of global liquidity, and stock prices go down.

One good bet in this market is the Japanese yen. It surged against the US dollar this week. Another good though less-sure bet is that stocks will go lower before they go higher. The question becomes how low will they go?

Jack Crooks is pretty bearish. Mike Larson is standing on the tallest tower crying havoc and chaos. These are two very smart guys. Me, I'm worried, but not THAT worried. I take a more long-term view, and the long-term fundamentals driving the global commodity are still very strong and still in place.

Heck, it's more than just commodity fundamentals that are bullish. The earnings of S&P companies have soared in the past four years -- I think they've doubled -- and stock prices don't reflect that. In a way, some people could argue that stocks are undervalued.

Me, I think investor and consumer psychology counts for a lot. In the short-term, that seems to be bearish -- SOMEBODY is coming out every morning and putting stocks on sale. However, I think things could look very different in another week or two.

How low could things go? Let's look at a chart of the S&P/Toronto Stock Exchange Index and see where Canadian stocks stand ...

This is a daily chart of the S&P/TSX Composite. I've put a couple of things on here.
#1 shows where the 50-day moving average came in line with the short-term uptrend. That proved to be support on Thursday.
#2 shows where the long-term uptrend lines up (approximately) with a common 38% retracement.
#3 shows RSI, which measures momentum and has gone bearish on a daily chart, showing there is likely more work to be done on the downside.

Now, some common retracement levels are 25%, 38% and 50%. These are support levels that show where an index or equity could pull back in a trend and still maintain that trend. I'm measuring mine from 2005, because that's when money started to pour into commodities. In that case, a 25% retracement brings us to around12,390. 38% is 11,841 (close to the long-term uptrend), and 50% is at 11,350. That's right, the TSX could pull back from its peak above 13,400 all the way to 11,350 and still be in a bull market.

And this is shorter-term -- since 2005. The Canadian stock market really turned around in 2002. closing at around 5978. Doing retracement levels from THAT level, first support (25%) comes in at 11,550. I won't tell you how low the other levels are because it's too early to start drinking.

Do I think it will come to that? No. Despite this recent pullback in China, that economy is super-strong. Ditto for India. In fact, the global economy is humming along. And that will fuel the continue global appetite for metals, energy, you name it.

So how low do I think the major indices could go? Well, measuring from 2005 again, I checked the percentage pullbacks every time the TSX closed below its 10-day moving average. The AVERAGE pullback was 7.2%, and the deepest was 12.5%. This is just since 2005, mind you -- do you remember that 12.5% pullback? How easily we erase the bad news from our memories.

As of Thursday's close, the TSX is 3.8% off its highs. So it has a ways to go just to get to an AVERAGE pullback of 7.2%.

A pullback to 12,000 would be a 10.7% pullback. And a pullback to 11,841 (the 38% retracment, and close to the long-term uptrend) would be a 12% pullback. THESE are my targets for buying again.

To be sure, the bottom could come a lot sooner than that. As I said, the underlying fundamentals are GREAT. But I'm glad we sold two positions to raise cash in Red-Hot Canadian Small-Caps yesterday. That money will come in handy later when there are bargain-priced stocks just waiting to be picked up.

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