A Breakout Quarter for this New Leader?

Investing is an Unnatural Business

Short-term vs. Long-Term Sentiment

A Breakout Quarter for this New Leader?

Legendary investor Jesse Livermore once wrote that “speculation must be an unnatural sort of business, because I find that the average speculator has arrayed against him his own nature. The weaknesses that all men are prone to are fatal to success in speculation—usually those very weaknesses that make him likeable to his fellows or that he himself particularly guards against in those other ventures of his where they are not nearly so dangerous as when he is trading in commodities or stocks.”

Livermore was mainly talking about how people can be their own worst enemy in the market, something that I’ve written about many times. But I think being in this business is “unnatural” because it messes with your emotions … the same emotions that rule the rest of your “normal” life.

In normal life, for instance, things tend to be pretty linear—on one end of the spectrum is good, on the other, bad. You want the things you care about—your kids’ grades, your favorite football team’s record, your bank account—to be as high up the “good” scale as possible, or at least, as far away from the “bad” end of the scale as can be.

However, in the market, things tend to be more circular—bull markets follow bear markets, greed gives way to fear, and then back again. Because of that, if you’re involved in the stock market, you obviously want things to be good … but not too good! If all the news is bullish and everyone is optimistic, it’s likely that most investors have already put their money to work. But when there are no more buyers, the sellers take control!

Of course, that’s a theoretical example—there’s always some extra money that could be invested in stocks. But the point is that when investor sentiment gets too bubbly, it’s usually a sign that (a) most investors have already done a lot of buying, and (b) their stocks have gone up a lot. And that doesn’t happen near market bottoms.

And that brings me back to the “unnatural” part about being a stock investor. If you’ve been around the block a few times like I have, you start to subconsciously wince when you begin hearing too many good things. It’s sad but true! Happy emails from subscribers are always welcome, but I get nervous when every phone call begins with “Hey, you guys are great! I’ve never seen anyone as good as you!” Though we’re very grateful for the compliments, we groan and wonder if the market advance is getting grey at the temples.

Conversely, when the market has been down for a couple of months, I often see some type of crystallization of bearish sentiment—a bad jobs report that hits the market, or maybe one of our recommended stocks gets hit on earnings—that comes darn close to marking a low. Again, it’s not that I crave bad news, but in this business, a little bad news often tells you better times are ahead, which means opportunities are at hand.

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If you’re new to the market, or to Cabot, all of this might sound insane. But it’s actually just the theory of contrary opinion playing out. Investor sentiment is an inexact market timing tool, but oodles of research has proven that market tops occur when most investors are optimistic, while bottoms occur during bad news and major worries.

That is why so many investors get sub-par results in the market—it’s a contrary animal, and if you invest based on how you feel, you’ll end up chasing your tail.

Usually I monitor a couple of basic sentiment indicators—the put-call ratio of options, the Investors Intelligence survey of stock market advisories, etc.—and keep my eyes and ears open for other anecdotal tidbits. That’s enough to let me know when the crowd is tilting too far in either direction.

What’s interesting nowadays, though, is that for the first time in my investing career, I’m seeing a huge divergence between what I call short-term sentiment and long-term sentiment.

Short-term sentiment includes the types of things I just mentioned—some market indicators and the general level of enthusiasm (or pessimism) among subscribers and other investors we know.

Right now, I think short-term sentiment is very bubbly; most investors I talk to are bullish, have made a lot of money, and aren’t too concerned when one of their stocks sells off for two or three weeks. Moreover, nearly every subscriber I talk to thanks me for doing such a wonderful job! Again, I appreciate that very much, but I’m no smarter now than I was, say, a year ago when the market was struggling.

Many objective measures like the put-call ratio have recently reached their most optimistic level in two or three years.

None of that makes me feel too happy … but then I look at the cover of Barron’s from two weeks ago, titled “The Snail Economy,” which says that “Over the next 20 years, the U.S. economy is likely to grow only 2% a year. That’s down from 3% or better since World War II.” This is pretty typical of most thinking; according to various polls, the vast majority of Americans agree that this country is on the wrong track, standards of living are expected to get worse, and, investing-wise, while a little risk-taking is OK, most are more interested with safety than growth.

Now, personally, I think this is totally false. Was anyone talking about a decade or more of 1%-ish growth back in 2000, when Internet stocks were racing ahead and we were running surpluses in Washington? Nope! Yet that’s exactly what has transpired during the past 13 years.

Now, though, after a long, hard slog in the economy, people are expecting it to continue. But history tells us that the economy is much more likely to accelerate in the years ahead, rather than continue at this moribund pace. Again, spring follows winter, and after such a long period of economic adjustments, the rubber band is likely to snap back in the other (faster growth) direction.

Anyway, that’s my opinion. My bigger point is that the type of groupthink that inspired the Barron’s cover is an example of long-term sentiment—despite lots of good feelings today, most investors don’t believe we’re on the road to riches. They think this year’s strength is more like a break in a decade-long rainstorm, probably “artificially” bolstered by the Fed’s money printing. The subtext: Enjoy it while it lasts.

So what does it all mean? Honestly, I haven’t lived through a period quite like this. My gut tells me that the current level of complacency means another shakeout or pullback or correction or whatever you want to call it could come soon. There doesn’t seem to be much to worry about, and when that happens, the market usually finds something to worry about (often an item few investors are paying attention to).

Long-term, though, the dour long-term sentiment among subscribers and men-on-the-street reinforces my general view that we’re either already done with the secular bear market (which began in 2000), or we’re in its 8th inning—maybe there’s one more mini-bear move out there of the 15% variety, or maybe not. But the fact that stocks are at new all-time highs, and most people are still disgusted at Wall Street, is encouraging from a contrary opinion standpoint.

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As for the current environment, I think the throw-a-dart-and-make-money phase is, unfortunately, over. This summer was a great time for growth stock investors, but October saw many highfliers come back to Earth, while the broad market picked up steam. This week, we’re actually seeing some money flow back into growth names as interest rates and the U.S. dollar pick up steam.

This rotation isn’t a bad thing, but the crosscurrents among individual stocks and sectors means you have to pick your spots when doing new buying. Of course, I’m always selective when recommending new stocks (sometimes I’m too picky), but now I’m really focused on stocks that haven’t made huge runs in recent months—or, if they have, they have based out for at least four or five weeks—have great growth prospects, and have shown big-volume buying of late, preferably after earnings.

One name I like is Align Technologies (ALGN), a firm that recently blew away earnings estimates and gapped to new highs as a result. Here’s what I wrote about the stock in Cabot Top Ten Trader two weeks ago:

“Align Technology’s big idea is Invisalign, a clear, nearly invisible plastic appliance that straightens teeth in a series of two-week steps. Invisalign appliances look like retainers, but they move teeth into line without the shiny array of metal strips and wires that make braces so uncomfortable in every sense. Align Technology also makes CAD/CAM software and dental scanners, but the Invisalign system is responsible for more than 90% of the company’s revenue. The firm has been expanding rapidly into the Asia-Pacific region, which is the fastest-growing region in the world for orthodontic work. The most recent evidence of Align Technology’s success came with the company’s Q3 earnings report on October 17. The company reported revenue of $165 million and EPS of 42 cents, topping consensus estimates of $159 million in revenue and earnings of 30 cents per share. Management also issued guidance for Q4 of $169 million and 41 to 43 cents in earnings, well above analysts’ previous estimates. All in all, Align Technology looks to have a product with a distinct advantage over its main competition that’s finding a widening customer base.”

Probably my main worry with ALGN is that the valuation has always been rich—it’s trading at 44 times earnings, and while I am not a valuation guy, I know the stock will have to keep posting better-than-expected quarters to stay in favor.

I think it can do that. The third quarter’s revenue growth of 21% was the fastest since mid-2012, and earnings of 42 cents per share were a whopping 12 cents above estimates. Moreover, the stock wasn’t on many radar screens until its powerful earnings gap three weeks ago, and the tight pause since then tells me few big investors are willing to sell their shares.

I think ALGN is buyable around here, with a stop near 50 or 51 to keep risk in check. For further updates on ALGN, consider a trial subscription to the Cabot Top Ten Trader. Each week you’ll get ten strong momentum stocks like ALGN delivered to your inbox. For details, click here.

Working to make you a better investor,

Michael Cintolo
Chief Analyst of Cabot Market Letter
and Cabot Top Ten Trader

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