Brokers Insist on it, Investors Swear by It
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Every now and again I like to do a question and answer issue of Cabot Wealth Advisory–we editors at Cabot spend hours each week answering subscriber questions, so we have a large pool to choose from. I think it’s a good idea to share some of these questions with everyone, as much can be learned from a good question and a good answer.
So, with the market still building a bottom (in my humble opinion), now’s a good time to build up your knowledge database, so to speak, and begin preparing for the next bull move. I hope you enjoy!
Question: You’ve written lately that you believe the market has bottomed, and yet the Model Portfolio in Cabot Market Letter remains heavily in cash. What gives?
Answer: Though many don’t know it, there’s a big difference between the absolute market low, and the right time to begin buying aggressively. The latter usually occurs a few weeks (sometimes longer) after the major low.
Why? It’s simple–institutional investors, the ones that move the market, take time to sell the stocks they don’t want, and take time to get into stocks they do want. That process leads to lots of choppy action, lots of rotation among sectors, and plenty of whipsaw moves. We’ve seen plenty of this in recent weeks, and it’s the main reason that investors who buy heavily during a bottoming process usually lose money.
Eventually, once this process is complete, the real leaders of the next advance–those with the best growth stories and numbers, and with the best relative strength–take off and enjoy sustainable advances. That’s the right time to buy aggressively.
The obvious example was the end of the last bull market, when the absolute low came in October 2002, while the bull market didn’t begin in earnest until March 2003. I don’t expect the current process to take anywhere near that long, simply because that decline lasted for years. But it shows that time is needed.
Bear Market Repeat?
Question: Do you believe this bear market has any chance of being like 2000-2002? If not, why not?
Answer: I joined Cabot in June 1999, and since then, I’ve seen a dramatic bubble, a tremendous decline, a multi-year recovery, and lastly, the current bear market.
So I know that anything–absolutely anything–is possible. But I seriously doubt we’re in for another two- or three-year decline. The reasons are many, but the key ones include:
The 2003-2007 bull market enjoyed a relatively mild advance, compared to the hot and heavy run-up of 1995-1999. That means less speculative excesses have to be quashed.
Pessimism is already rampant. Whereas many investors stayed bullish most of the way down in the 2000-2002 bear market, most investors are outright bearish right now, after ten months of bear action.
The average bear market lasts about nine months and loses 25%–about in line with what we’ve already seen. The severity of the 2000-2002 bear market has happened just a couple other times in history.
Like I said, anything is possible, but the odds are very much against a prolonged bear market this time around, at least when compared to the prior meltdown. These are some of the reasons I think the odds favor us being in the seventh or eighth inning of this bear phase, as opposed to the third or fourth inning.
Question: In Cabot Top Ten Report, I noticed you sold XYZ stock, yet the shares are acting fine. Why did you sell out?
Answer: In recent years, especially in tricky environments like now, we’ve been doing more offensive selling–i.e., selling some shares on the way up. And sometimes, we’ll just sell the whole thing.
My experience tells me that investors don’t like to sell. They don’t like to sell winners because they’re performing well. And they don’t like to sell losers because they don’t want to “realize” the loss. (Like that means anything.)
But the proper thing to do is to cut ALL losses short when buying growth stocks, and to also sell a few of your less vibrant stocks when you’re up 10% or 20%. That’s not your ultimate goal when you buy a stock, but sometimes, when a stock isn’t living up to expectations, it’s best to get out while the getting is good.
Successful investing is not about being right on every stock, or riding a stock as long as possible. It’s about making money, and to do that, you have to sell some stocks on the way up.
Finding a Low Point
Question: Can the market bottom if the worst sectors of the bear market (financials) continue to head south?
Answer: Likely not. My studies show that the worst sectors of the bear market need to hit a low point before a new bull market begins.
Note, however, that these sectors–financials in this case–don’t lead the next bull market. Back in 2003, for instance, it wasn’t bubble boys Cisco, Juniper, JDS Uniphase and Nortel that led the way higher. It was newer stocks with newer stories that hadn’t gone through the wringer.
Question: You talk about a stock trading “thinly.” What does this mean? And why is it a bad thing?
Answer: Thinness refers to how many shares, or how much dollar volume, a stock trades each day. For our purposes, we consider any stock that trades less than 500,000 shares per day to be relatively thin.
Being thin isn’t bad, per se, but it usually means that big institutions can’t take large positions in the stock. And if institutions aren’t involved, the stock is going to be very choppy as small hedge funds and other small investors buy and sell. With more heavily traded, institutional-quality stocks, big investors will support shares during most normal pullbacks.
If you run a widely diversified portfolio, buying thinner stocks can be fine, and even fruitful. There’s nothing wrong with them. But if you concentrate all your eggs in just a few baskets, and you don’t have the biggest risk tolerance, you might want to stick with stocks that trade at least 500,000 shares to a million shares or more each day.
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Why Not Short Stocks
Question: Why don’t you short stocks in your newsletters? Seems like it would be a good way to make some money during bear markets.
Answer: We have nothing against shorting, but most investors don’t realize that making money on the short side is MUCH more difficult than making money on the long side.
Why? Because fear is a more intense emotion than greed; when a stock declines, it happens quicker than when it rises. And that means your timing must be much more precise when shorting–if you’re off by a day or two, the stock can rally quickly and force you to take a loss.
It’s also mentally hard for most investors to play the short side, since all the work and research we do is geared toward finding big winners during bull markets. In a way, playing both the long and short side is like using two different systems, which can easily play with your mind.
Fundamental Stock-Picking Criteria
Question: What would you say is your most successful fundamental stock-picking criteria?
Answer: If I had to pick just one, it would be triple-digit revenue growth. Companies that are growing that fast, especially if it’s because of a new product or service, often turn into big market winners. It’s important to make sure the 100%+ revenue growth is happening because of internal growth, not because of acquisitions.
If I had to pick one other, it would be a new revolutionary product, like Apple’s iPod, Crocs’ croslite shoes, Google’s paid search, XM Satellite Radio’s, um, satellite radios, and First Solar’s silicon-free solar panels–all of which were Cabot winners in recent years.
Future of Commodities
Question: In a prior Cabot Wealth Advisory, you wrote that commodity stocks were dead, and should be sold. How did you see that coming? And what do you think of them now?
(Editor’s Note: This refers to the July 10, 2008 issue.)
Answer: One key sell rule you can use is this: If a stock or group has had an extended run-up during the past two, three or more months, and then most stocks in the group suffer their biggest down day on their heaviest volume of the upmove, then the top is in. This is especially true if most of the stocks in the group break below their 50-day moving averages.
Of course, this is all based on technical action, not fundamentals. But it doesn’t matter. I’ve seen it work many times in the past, and it worked again in early July of this year, as all the steel, coal, oil and natural gas stocks were crushed. It was a sign that perception and sentiment in the group had switched–the big money crowd was jumping ship.
As for right now, I do believe many of these names can bounce, but I don’t advise playing the bounce. Until I see signs of big-volume support, I would avoid all commodity stocks. They may still be in a longer-term bull market, but to be honest, many of the stocks have suffered abnormal declines, which makes me wonder.
Seasons in the Market
Question: I know that August, September and October are three of the worst months in the stock market. Does that mean we’re likely to stay in the dumps until the end of the year?
Answer: We’re not huge fans of seasonality. It’s true that, over time, the market has done most of its good work between November and April. But that’s just an average. Some years it does, some years it doesn’t.
Last October, for instance, wasn’t a bottom, it was a top! And September was one of the best months of the year. Similarly, in 2006, the market bottomed in mid-July and had a good August, September and October.
It’s good to have seasonality on your side, but it’s not nearly the be-all and end-all of your investment plan.
I hope you enjoyed the Q&A issue. If you have any comments, I’d be glad to hear them. So email us or go to iconoclast-investor.com to read our blog and post comments.
All the best,
Editors Note: Michael Cintolo is Vice President of Investments for Cabot, as well as editor of Cabot Market Letter. As a student of the market, he knows what a new bull market looks like, and while most investors are panicking, he’s currently readying the Market Letter’s Model Portfolio for a big buying spree. He recently added two new growth stocks, and anticipates buying many more once this bottoming process is finished. So if you want to know his latest thinking on the leaders of the next bull market, give Cabot Market Letter a try.