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Managing Your Stock Portfolio to the Market’s Tune

In today’s Wealth Advisory, I’m doing something I’ve never done before—reprinting an entire piece I wrote in Cabot Growth Investor last Wednesday. It doesn’t involve any specific stock advice (that is and always will be for subscribers only), but it details the wild divergences in the market (which are now getting lots of press—even the Wall Street Journal had a big write-up on it Monday), what it means, and how I’m advising people to handle it—I think it’s very timely.

Managing Your Stock Portfolio to the Market’s Tune

Focus on the Best

A One-of-a-Kind Retail Stock with Huge Potential

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Managing Your Stock Portfolio to the Market’s Tune

In today’s Wealth Advisory, I’m doing something I’ve never done before—reprinting an entire piece I wrote in Cabot Growth Investor last Wednesday. It doesn’t involve any specific stock advice (that is and always will be for subscribers only), but it details the wild divergences in the market (which are now getting lots of press—even the Wall Street Journal had a big write-up on it Monday), what it means, and how I’m advising people to handle it—I think it’s very timely. Here it is:

    “Growth stocks and growth-oriented indexes have come alive in recent days, which is music to our ears. If this morphs into a sustained advance, it would be the first for growth stocks since early 2014! So far, so good.

    However, we all know that growth stocks don’t live in a vacuum, which is why we also focus on the major indexes and the health of the broad market. The ideal situation is when everything is going up (markets are healthiest when all indexes and stocks are “in gear” on the upside) and growth stocks are leading the way. The current environment, on the other hand, is a mixed bag—growth stocks are showing promise, but wide swaths of the broad market are struggling and many leading breadth indicators are waving yellow flags.

    The most important of these is the Two-Second Indicator, which simply measures the number of stocks hitting new lows on the NYSE every day. (In healthy markets, the figures are almost always fewer than 40 each day.) Despite the recent rally in the market, this indicator has regularly recorded new low readings above 100, including a whopping 485 this Monday! And it’s not just one sector or a bunch of preferred stocks hitting new lows—just about every energy and commodity stock is under pressure, as are many interest rate-sensitive issues (utilities and REITs remain weak, as well as a few yieldcos) and more than a few large retail firms are on the list. So the weakness is widespread.

    Painting a similar picture is the NYSE Advance-Decline Line. It topped out in mid- May and slid sharply into early July. The recent bounce has been decent, but it remains well off its highs right now.

    All of this has us on alert because, historically, the Two-Second Indicator will wave a yellow flag (as it’s doing now), and the A-D Line will reach its ultimate peak, several weeks ahead of a major bull market top. In 2007, for instance, both indicators started telling us something was up in June and July; the ultimate top came in October. In 1998, the A-D Line topped in April and the Two-Second gave a sell signal in May, prior to the mid-July peak. And in 1987, the A-D Line topped in March and the Two-Second turned negative in early September, ahead of the October crash. The 2000 divergence and topping process was an outlier, as it lasted well over a year before the bubble popped.

    All that said, we think it’s likely too soon to get too worried; as we just wrote, the Two-Second Indicator and A-D Line can (and often do) sound the alarm several weeks (even months) in advance of a major peak. So, even if you’re thinking we’re in the eighth inning of the bull market, stocks could still run for a while (the last rally is usually narrow and led by growth stocks, by the way). And beyond that, there’s nothing that says the market can’t soon enjoy a rally that brings with it most stocks and sectors, and lead to “all-clear” signals from the breadth indicators.

    Thus, when it comes to individual growth stocks, you shouldn’t sell a winner prematurely just because of these breadth measures. Instead, just stick with your plan and follow the action of the stocks themselves. So if you own a leader that’s acting fine, sit tight … but, on the flip side, if something trips your loss limit or trailing stop, honor that signal and get out.

    But where you should factor in the current message of these breadth indicators is when it comes to your overall portfolio stance. In the Model Portfolio, until we see signs that the broad market is participating, we’re likely to keep a chunk of cash on the sideline (at least 15%, and probably at least 20% to 25%, as we have now) as a cushion just in case the bears suddenly take control.”

That’s what I wrote a week ago and it still applies today. The message here is that, when it comes to secondary market timing indicators—meaning those that don’t focus on the price/volume action of the indexes or leading stocks—it’s best to take those into account via your overall portfolio (in this case, by holding more cash).

But you shouldn’t go out and sell XYZ stock if it’s doing fantastically; it’s best to handle that stock via your normal methods.

If, on the other hand, I saw a sell signal from a primary indicator (like the trend of the overall market turning bearish), that would be more important and urgent, forcing me to raise more cash and/or keep tighter stops on my stocks.

This is exactly how I manage the Model Portfolio in Cabot Growth Investor—always staying in step with what the market is doing, following our proven market timing indicators and yet giving the dynamic growth stocks (my bread and butter) in our Model Portfolio room to run. All of this is a big reason why Growth Investor has more than doubled the market’s return since I took over eight years ago! Click here to learn more.

Focus on the Best

Moving on to individual stocks, I’m always on the lookout for potential new leadership no matter what the market is doing, and the good news is that, despite the minefield of the market, many growth stocks continue to act well.

Given the tricky overall environment, I’m focusing on the very-best-of-the-best stories and set-ups. That means looking for (a) a history of strong sales and earnings growth, (b) big earnings estimates for the next couple of years, (c) a unique growth story and, importantly, (d) a stock that’s offering a lower-risk entry point—one that’s shown strength but isn’t extended to the upside (which leaves you vulnerable to any market wobble).

One stock that fills the bill is Restoration Hardware (RH), which is on my watch list. Believe it or not, I’ve been watching the stock for about a year—it was my Top Pick at the 2014 Cabot Investors Conference, nearly one year ago—and now, after a ton of starts and stops, shares look poised to get going. Here was my take on RH on July 13, 2015, when I recommended the stock in Cabot Top Ten Trader:

    “Restoration Hardware is usually thought of as another high-end retailer of home furnishings, but the stock is perched near all-time highs today because the story is far more enticing than that. The company has a one-of-a-kind business model, as it’s been closing its mall-based stores and instead focused on (a) huge, 50,000-foot (or larger!) showrooms in key cities across the country that can display a huge portion of the company’s high-end products, (b) gigantic once-a-year catalogs (called source books) and (c) vast partnerships and relationships with leading global designers.”

rh

Combine all of that with a new concept or two each year—Restoration Hardware just announced a new Modern line of products that should appeal to an entirely new category of customers (it’s current line is mostly classic looking). That new line will have a 300-page source book of its own and a 15,000 square foot store in Los Angeles—and there’s reason to believe the company should enjoy healthy growth for many years to come.

Even in the midst of the firm’s transition to its huge showroom strategy, sales, earnings and profit margins are doing great and analysts see earnings up 32% this year, 25% next year, and more 20%-plus growth after that. It’s a unique retail story that has a lot to like.

Chart-wise, RH has had numerous runs to new price highs … but the move usually lasts just a week or two before it tucks its head back into its shell. That’s what’s kept me watching, and not buying, the stock for the better part of a year.

Now, however, I think the stock may have changed character. First, it reacted well to earnings in mid-June. Second, even after a dilutive convertible bond offering, shares held firm. And third, RH lifted to new highs on good volume as soon as the market bounced following the China/Greece mess.

RH has come down a few points during the market’s latest selloff, but as we saw a few weeks ago, the selling has been minor; the stock is still above its 25-day moving average. The bottom line is that the stock’s pullback, which coincides with the drop in growth stocks this week, appears normal.

Along with the company’s excellent fundamentals and prospects, I think RH is primed to do very well, assuming the market doesn’t implode. At the moment, I’m going to keep the stock on my watch list, but if you’re game, I think buying a small position (maybe half to two-thirds of what you’d normally buy, dollar-wise) here with a stop near 96 should work very well.

Sincerely,

Mike Cintolo,
Chief Analyst, Cabot Top Ten Trader and Cabot Growth Investor

A growth stock and market timing expert, Michael Cintolo is Chief Investment Strategist of Cabot Wealth Network and Chief Analyst of Cabot Growth Investor and Cabot Top Ten Trader. Since joining Cabot in 1999, Mike has uncovered exceptional growth stocks and helped to create new tools and rules for buying and selling stocks. Perhaps most notable was his development of the proprietary trend-following market timing system, Cabot Tides, which has helped Cabot place among the top handful of market-timing newsletters numerous times.