Investing Questions Answered– You Ask, I Answer!
Sell Rules, Stops, What to Do with Extended Stocks
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One thing I believe that truly makes Cabot unique in the investment publishing industry is that all of us editors answer subscriber questions. We’ve done it for years and continue to make it a point to respond to subscribers’ questions in short order.
Personally, I probably field a few dozen emails every week, along with maybe a dozen phone calls, but it varies—during earnings season or other volatile market times, I might be on the phone for a couple of hours a day. Other times, around the holidays, I might answer just a few emails a week.
But the idea is that we’re accessible and accountable, and help out whenever we can. I really don’t know of any other advisories that do what we do.
One benefit of taking these questions is that we’re able to find out what common themes or questions are on most investors’ minds. And that helps with our writings, and leads us to do the occasional Q & A version of Wealth Advisory … like I’m doing today.
Thus, below I’ve collecteda few common questions and topics I’ve been getting in recent weeks; together they probably represent 70% of the emails and calls I’ve been fielding in that time. Without further ado …
Q: “I have been watching XYZ stock for weeks, hoping for a pullback to buy … but it hasn’t pulled back? Should I just jump in here?”
A: This is probably the most common question I get during strong market uptrends. After all, the best stocks rarely offer pristine buy points; investors who wait for a calm, three-week tight area with the 50-day line catching up rarely get the opportunity. Instead, the most powerful leaders have only brief and shallow pullbacks as big investors pile in.
So, you should just buy in, right? Not exactly. The answer to this question really comes in two parts. First, you could solve a lot of the problem of “missing out” on big winners by following sound buy rules. For instance, LinkedIn (LNKD) and Cree (CREE), two of the bigger growth stock winners of this rally, were buyable on their initial earnings gap higher (CREE at 40 in mid-January, LNKD at 145 or so in early February). Most investors don’t buy those kinds of moves, but my studies show they’re pretty high probability bets.
However, if you genuinely did miss the move for whatever reason, my advice is to “think smaller”—still look for pullbacks, but instead of holding out for a 10% drop, look to get in on a dip of 2% to 4%. Furthermore, you should also think about buying a smaller position; if you normally buy $10,000 of a stock (to pull a figure out of thin air), consider buying $5,000 or $6,000, with the idea of buying the rest if (and only if!) the stock does well from there.
My only other heads-up about this issue is this: If you do decide to go with the “think smaller” approach, try to restrict it to just one or two stocks; you don’t want to use the smaller position as a crutch that allows you to sneak into a bunch of second-rate stocks that have already made huge moves. As always, you want to stick with the true market leaders.
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Q: “Hi Mike, I’ve been lucky/good enough to grab hold of some nice winners this year and have, for the most part, ridden them to nice gains. But now my question is: When do I sell? I’ve ridden many stocks up-and-back-down in recent years and don’t feel like giving up all of my gains.”
A: This is really the epic question that has been around since speculators first began trading: When do I sell? I could list a few sell rules (50-day moving average, take partial profits once your profit is twice your risk, etc.), but at the end of the day, when you’re examining the risk, you have to simply make a call and determine how much of your gains (whether it’s in a stock or your total portfolio) you’re willing to give back.
The famous trader Ed Seykota once said that “no matter what kind of math you use, you wind up measuring volatility with your gut.” Part of what he meant was that each individual investor has to determine how much risk (and, hence, potential reward) he’s willing to take.
One thing to remember is that no system, no matter how good, is going to get you to sell at the top. It’s not going to happen. So you are either going to sell early … or late. It’s that simple. Just accept it.
When you come to this fork in the road, you should sit down when the market is closed (ideally the weekend) and lay out a game plan—set some mental or market stops, decide what you’ll do if the market does this or that, etc. Then follow your plan!
Now, as for some very general guidelines, I wouldn’t give back a profit of, say, 15% or 20% in an individual stock, and for your overall portfolio, you shouldn’t give up a gain of, say, 10%. If you’re consistently riding things up and then all the way back down, chances are you have no sell rules, or you can’t force yourself to follow them.
But beyond that, it’s really about how much risk you want to take—the quicker you sell, the more gain you’ll keep … but the more chance you’ll be left on the sideline should the market’s uptrend reassert itself. And vice versa. Your best ally in this decision is some quiet time with a spreadsheet, figuring out what plan works best for you.
Q: “Mike, what are your thoughts about Apple (or Baidu or Priceline.com or any other past big winner that’s been languishing)?”
A: To me, this question really comes down to something I wrote about in Cabot Wealth Advisory a few weeks ago—having a checklist of criteria you want your stocks to have. It doesn’t have to be super detailed, but having a few filters will eliminate most of the second-rate stocks.
Thus, when I get a question about Apple or any of the other former big winners that look poor, I simply say “I have no interest; we’re looking for stocks that are in uptrends, not downtrends.” And, no matter how much you might love the company, Apple’s stock is most definitely in a downtrend.
That doesn’t mean I’m super bearish on that or the other past winners. Who knows—maybe something like Baidu will right itself in the months ahead, sales and earnings growth will accelerate and the stock will set up a good buy point. Or maybe it’s topped permanently and is headed down another 35%. I have no idea.
All I know is that if you’d been trying to pick the bottom in these names for the past few months, you’d be losing money … all while the market has enjoyed a great run. Stick with the leaders!
Q: “Mike, I’m a big fan of the market timing indicators in Cabot Market Letter, but my question is what happens if there’s some sudden news overseas that causes the market to fall apart within a day or two or three? Will your indicators protect us in that scenario?
A: The answer is almost always yes, and that’s because of the way the market generally forms a meaningful top—specifically, it usually takes time, especially when you’re talking about the start of a bear market or a deep, prolonged correction. While individual stocks can top out in the blink of an eye, the market as a whole doesn’t do that.
But what about all of the sudden selloffs we’ve seen over the years, whether it’s 1987, the Flash Crash in 2010 or the summer meltdown in 2011 during the debt ceiling debate? Well, believe it or not, the market had deteriorated significantly for weeks before all of those sharp downmoves—so we had been backing off for weeks before the big downmoves.
Thus, despite the still-worrisome headlines (Cyprus is the disaster du jour), the odds of the market simply falling off a cliff and having a mini-crash are very small. Of course, that doesn’t mean the market can’t begin to fall apart and then really unravel later on … but by that point, we’ve usually gotten sell signals from our indicators, and from our individual stocks, and have raised plenty of cash as a result.
Remember, the big advantage of trend-following market timing systems is that you’ll never sit out a major upmove, and you’ll never be a deer-in-the-headlights during prolonged downmoves. Historically, these indicators have helped us immensely.
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Q: “Hi Mike, I’ve been following your advice this year and am up XYZ% so far this year. Is that good? Should I be doing better? What’s a reasonable return for following Cabot Top Ten Trader?”
A: I’ll end on this question, which is a good one. It totally depends on how you trade—even if two investors are buying and selling the exact same stocks at the exact same time, if one is taking, say, 10% positions, and the other is taking 20% positions, their returns and volatility will vary greatly.
Of course, you can always compare your performance to the major indexes, but if you manage your portfolio somewhat conservatively (booking partial profits, keeping positions in check, etc.), that might be unfair. Conversely, if you’re more of a swashbuckler (love that word), you probably should be doing better than the major indexes during a strong market upmove.
Your best measures of success will come from (a) comparing how you’re doing in this environment compared to past market uptrends; that’s one reason it’s important to keep records of your performance, and (b) more generally, whether you’re sticking with sound rules and tools. In other words, focus on your process (following the plan), not just your results.
As for the current market, my simple description is good-not-great. The trend is still most definitely up, which is most important, but just during the past week or two I’ve seen a few yellow flags—each one of them individually isn’t a big deal, but collectively, it’s caused my antennae to go up.
First, there’s been a lack of volume on up market days and a bunch of volume during market selloffs. Second, I’m starting to see some churning, i.e., the market is going up and down and all around, but not making any upward progress. Third, defensive stocks (I use the Consumer Staples fund, symbol XLP, as a proxy) are outperforming, while “riskier” growth stocks are lagging.
Combine that with a strong, persistent run since mid-November (and especially since the start of January), and there’s the potential for a meaningful selloff … but I’m not necessarily predicting that. To me, the right thing to do is to use your head—with the trend still up, you should remain bullish, but it’s OK to book some partial profits (if you own some stocks that are extended to the upside), dump some laggards and hold a little cash.
However, I wouldn’t ditch the buy side at all—in fact, even if we do get a good shakeout in the market, I think it could lead to some decent entry points in a few leaders. One I’m going to highlight today is Aruba Networks (ARUN), which I wrote about in Cabot Top Ten Trader a week ago Monday:
“These days, just about everyone you know probably owns a smartphone, tablet or both, and they use them all the time. Yet when these same people head to work, they usually have to use a company-issued laptop or smartphone to access the company’s network and any important data; it’s the company’s way of ensuring proper security and access rights (so employees only get access to stuff they’re supposed to). It makes sense, but it’s tremendously cumbersome and results in a ton of extra cost for the company. Enter Aruba Networks, which is focused on providing networking equipment that allows so-called BYOD (Bring Your Own Device), helping companies and other large entities (government agencies, college or other campuses, etc.) save money, simplify operations and, importantly, make life easier for employees. Aruba has competition from the usual suspects like Cisco, but management remains confident that their technology is best-in-class; in the latest conference call, the top brass said their win rate against Cisco may have actually increased of late, despite some new Cisco product introductions. Analysts see earnings growth in the 25% to 30% range for the next few quarters, and while Aruba doesn’t offer anything revolutionary, we think demand for its BYOD solutions should stay strong for a long time. We like it.”
The stock peaked in early 2011 and went through the wringer until the middle of last year, when it bounced for a while and then etched a four-month base. The breakout came a few weeks ago after a great quarterly report, and since then, ARUN has traded in a tight range (24-26) despite the market’s ups and downs. I think it’s buyable around here with a stop around 23, but if you want to wait for a powerful move above 26.25, that might lessen your odds of getting tossed around.
All the best,
Editor of Cabot Top Ten Trader
and Cabot Market Letter
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