How the Market Actually Works - Cabot Wealth Network

How the Market Actually Works

How the Market Actually Works

Why January is Very Important in 2010

Stock Idea from a Trick of the Trade

The beginning of a new year is a natural time to clear your mental decks and remind yourself of the basic principles of successful investing.  Don’t worry:  I’m not going to spend two pages detailing my system, which I know would cause more than a few glazed eyeballs.

But, for my first Cabot Wealthy Advisory of 2010, I wanted to start off with a section I like to call “How the Market ACTUALLY Works.”  What does that mean?  Simply that so much of the advice and so-called facts that you hear on TV and read about in financial magazines is basically nonsense.  I found that out the hard way. By losing money!

Over the years, however, I became a veteran student of the market, using market history and observation to discover how the market actually works … as opposed to how many investors think it works.  Nothing below is revolutionary, but as I wrote above, it’s good to remind yourself of the basics to stay on a path to profits.

So, here are some things to keep in mind as you enter the market’s battles of 2010:

Price doesn’t matter:  The price of a stock is NOT a predictor of success.  So if you’re eliminating higher-priced stocks from your buy lists, you’re eliminating many potential winners.  The fact is, no institutional investor avoids high-priced stocks, and it doesn’t matter if you own 10 shares or 100 shares.  All that matters is how much MONEY you’ve invested.  Personally, I rarely buy in round lots, instead buying a set dollar amount.

For growth stocks, valuation is a result of performance, not the cause of it: P/E ratios get lots of attention, but the fact is they’ve proven to have little predictive value either for an individual stock, or for the market as a whole.  Believe it!  Other factors–such as sales growth, earnings growth, sponsorship and potential for continuing upside surprises–are far more important.  Historically, the biggest winning stocks have always begun their runs with huge P/E ratios.

Don’t get too concerned by insider selling:  Like P/E ratios, insider selling elicits big emotions from many investors.  After all, if the top brass is selling, why should you sit tight?  But in reality, things aren’t that clear cut.  First, management might be selling some shares, but getting more in options or future compensation.  And second, big-winning stocks are usually entrepreneurial … so these people may have worked there for years and have a chance to cash in some of their shares.  Either way, there hasn’t been any strong correlation between insider selling and future performance; sometimes it marks tops, but oftentimes it doesn’t.

Strength begets strength … to a point:  Too many investors fall into the trap of looking for the stock that hasn’t yet advanced, thinking it’s “due” to “catch up” to its peers.  Most of the time, that’s an error–you want to invest in the leaders, which are usually the first stocks in a group (or the entire market) to hit new peaks.  Of course, you don’t want to buy a stock that’s been soaring for six months in a row and is very extended; that’s where chart reading comes into play.  Ideally, you’re buying a stock that has consolidated for a couple of months and has just broken out to new peaks.

Trailing stops are nice … but do the math:  Most investors I correspond with like to use a pre-determined trailing stop, say, 20% down from a stock’s peak.  Thus, you’ll never lose more than 20% off a stock’s high–but realize that 20% is a lot!  For instance, if you only sell using this method, just to break even you’re going to have to pick a stock that first rises 25%.  And to make 50% on your investment, a stock must first rise 88%!  Thus, it’s usually better to sell some shares offensively (on the way up in price) while using a trailing stop for the rest of your shares, giving yourself a chance at a home run.

Stock splits tend to be negative, not positive:  Yes, sometimes a stock will pop on a stock split announcement, but you should know that many of the best stocks will top out on or soon after a split … especially if it’s the stock’s second or third split in a year or two.  So if you’ve got a big winner you’ve ridden for months, and it pops on a split announcement, you should consider selling some.

Sales growth is often more important than earnings growth:  There are many ways a firm can boost earnings, including cost cuts, layoffs and higher productivity.  But there’s only one way to grow revenue–and that’s to sell more!  Thus, excluding acquisitions, if you find a company consistently growing at 50% or more (100% or more is even better), you’re likely looking at a firm with a unique product or service … and a stock that could do very well.  (Historically, our top stock-picking tool has been triple-digit revenue growth.)

The market tells its own story best:  You shouldn’t pay much attention to predictions of where the market’s heading, or why it’s going to do such-and-such because of the U.S. dollar, commodities or China’s actions.  Remember that the market itself tells its own story best–so stay focused on the action of the indexes and of leading stocks.  They’ll give you the most accurate indication of what comes next.

There are more tricks of the trade, but these are enough to kick your portfolio off to a good start this year!

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Top Income, High-Yield and Dividend Picks for 2010

Did you know that income stocks that pay dividends have out-performed non-dividend-paying stocks by four to one over the past 35 years?

That’s because dividends tend to increase each year, more than 137 years of data point to the inescapable conclusion that owning dividend-paying stocks–and then re-investing those dividends–beats other investment approaches hands down. So if dividend-paying stocks make you yawn, it’s time to wake up and smell the cash.

And for a limited time, if you subscribe to Dick Davis Income Digest, you’ll also receive the Top Income, High-Yield and Dividend Picks for 2010! But hurry, the issue comes out next week!

For those who missed it, Barron’s had a great little write-up about the market’s finish in 2009 and what it could portend for 2010.  While I am not the biggest fan of seasonality studies (i.e., the market goes up X% of the time between July and September, etc.), this one caught my eye.  Here’s what was written (thanks to John K. Harris, author and market historian):

There have been 24 times in the 82-year history of the S&P 500 when that index hit its yearly high in December.  (It did so again in 2009.)  In those 24 instances, the market was positive the following January 18 times.  That’s nice, but what’s amazing is that the average return for the YEAR when January was positive was a whopping 17.2%.  For the six instances when January was negative, the index finished the entire year with an average loss of 3.5%.  That’s a big difference.

The study also found that there were 13 times the S&P 500 hit its yearly high after Christmas.  (Again, 2009 followed that script.)  Of those 13, nine showed a positive January … and when January was positive, the average return for the year was 19.4%.  In the other four instances, when January was negative, the average return for the year was a modest 0.6%.

Now, I don’t want you to assume that 2010 will be a downer if January is negative; seasonality is usually more of a breeze blowing with or against the market, as opposed to an iron fence.  

Even so, I found this study interesting for this logical reason:  If a market closes near its high for the year, and then continues that momentum in January (which is a notoriously tricky month), it’s basically telling you that stocks are in a primary bull market.  And that means higher prices are likely in the months ahead.

I also appreciated the vast differences between results–if January was positive, the year was very positive, if January was negative, the market was flat-to-negative.

Again, these are all averages, so don’t base your entire investment plan for 2010 on what happens during the next few weeks.  But I think it’s interesting enough for you to keep in the back of your mind!

My stock idea for today stems from a trick of the trade that I have begun to formalize after reviewing most of my 2009 trades.  Basically, when you get (a) an institutional quality stock that trades hundreds of thousands, if not millions, of shares per day that, (b) moves up to or close to new highs, preferably after a multi-week basing period, and (c) marches higher at least seven or eight days in a row, you’re usually looking at a “blast-off” of sorts.  The stock is a buy on any pullback.

It doesn’t always work out, but my experience tells me 70% or 80% of the time, these simple criteria can help you find at least good short-term trades, if not great longer-term entry points.

One stock that recently showed this type of strength is the bellwether of the natural gas sector–Southwestern Energy (SWN).  The stock had been etching a base for eight weeks before it bolted up from its bottom for nine days in a row.  And this week, it nosed out to new all-time (all-time!) high ground before easing back … particularly impressive for a commodity stock.

The company is expected to grow earnings 59% in 2010, thanks to a 36% hike in production and improved pricing for its natural gas.  Southwestern’s current leader is the Fayetteville Shale formation in Arkansas, which continues to churn out great wells. In fact, that shale formation is really the ruling reason to own SWN … that and the fact that top management that has expanded the firm’s business nearly without fail during the last decade.

With natural gas prices firming up (a breakout above $6 for natural gas would likely forecast higher prices), I think SWN will be a winner in the months ahead.  It looks buyable here, though a drop back below 45 would tell you something is amiss.

All the best,

Mike Cintolo

Editor’s Note: If you want to learn more rules for growth investors and get the top growth stock picks in the market, you should check out Cabot Market Letter, which is edited by Michael Cintolo. The Letter is top-ranked for both one-year and long-term market timing because it follows a finely tuned system that has been perfected during the last 39 years. Click the link below to find out more.


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