Lessons from a Student of the Market

October 1997, February 2007 and May 2010

Formulating a Game Plan

A Surprisingly Strong Stock

Being a student of the stock market means one thing above all else:  I’ve studied and experienced enough market history to know what is normal, and what is abnormal, in the action of the market and individual stocks.  And it also means that, when some wacky market action drops in my lap, I have a knowledge base to refer to, often finding similarities between the current environment and some episodes of the past.

However–and this is important–I focus solely on the market itself and Cabot’s market timing indicators, or the action of leading stocks.  I don’t care much about the news that “caused” the decline, but instead, how the market is reacting to that news.

For example, when last week’s market bombshell hit us, most pundits and commentators immediately pointed to the debt news out of Greece and how it was a continuation of the debt problems that caused the financial crisis in 2008.  And that led them to fear a further meltdown.  But last week reminded me much more of two other periods that I believe will provide the model for the next few weeks–October 1997 and February 2007.

In both of these cases, the market had the following general similarities with today’s environment.  First, both markets featured super-strong advances during the prior couple of months; the advance-decline line for the NYSE was hitting new multi-year highs in each case, there were hundreds of stocks hitting new peaks, and many leading stocks acted well.

And then, after a very brief pause, WHAM!, every case saw the major indexes suffer scary, “biggest drop in many months (or years)” type of declines.  Many leading stocks and all the major indexes broke down below their widely followed 50-day moving averages.  The volume during the decline was huge.  And many investors were shell-shocked … frightened that weeks worth of gains could be wiped out in a matter of days.

Also, in each case, there was widely accepted news that “caused” the event–in 1997 it was the Asian currency crises; in 2007, the crash in the Shanghai markets; and this year, of course, the aforementioned Greece debt crisis.

Underneath the surface, both of the prior instances saw the number of stocks hitting new lows on the NYSE only temporarily expand during the worst of the selloff.  In 1997, the Dow actually fell 500 points one day, and new lows jumped above 297, before tapering off in the weeks following.

In 2007, there were a handful of days of greater than 40 new lows, but nothing consistent despite the market’s 6% drop.  (Greater than 40 new lows, by the way, is a key level that can differentiate between healthy markets and unhealthy markets.  It’s the basis for the Two-Second Indicator used in Cabot Market Letter.)

And this year, when Dow slid as many as 1,000 points last Thursday, there were 218 stocks that hit new lows … but the number dried up to 60, 7 and 8 during the next three days!  

In other words, in each instance you had a strong bull market that stepped into a sudden, major ditch.  But what happened following the prior two occurrences?  The market took some time to build a bottom–about three months in 1997, but just one month in 2007–and then entered into a powerful new uptrend.

While I do not pretend to have a crystal ball, I think there’s a good chance history will repeat itself.  Namely, in the short-term, rallies will be sellable, and the volatility that began last week will continue for another few weeks.  Translation:  Expect lots of choppy action ahead.

During this time, however, we expect many leading stocks (including some new leaders) to build fresh launching pads.  The market might successfully re-test last week’s low.  And then we’ll enjoy another multi-week spurt higher, led by the best stocks the institutions are buying.

All of this leads to two questions, both of which I’ll answer below.

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Given the scenario I laid out, your first logical question should be … “What would change your mind?”

I would tend to think the market doesn’t need a new base-building phase if the major indexes rocketed back to new peaks, or got above their 50-day line and stayed there for four, five or six days.  For the record, I think this is a highly unusual outcome, but anything is possible in the stock market.

As for the downside, if the number of new lows rose above 40 and stayed there, day in and day out, and the market’s two best leading stocks–Apple (AAPL) and Baidu (BIDU)–both seriously cracked support on huge volume, that would be a sign this could be more than just a short-term correction.

While those two situations are something to watch, the evidence to this point, however, points to some bottom-building, and a resumption of the bull market in the weeks ahead.

The second question is, “Given your scenario, what’s your game plan?”

For me, in the short-term, it’s going to mostly be about taking it easy.  From late February through last week, it’s been busy around here, not just for work, but in managing investments.  So doing little of anything on the long or short side will help refresh my mental batteries for the next leg up.

However, doing little trading doesn’t mean I’ll be doing nothing.  In fact, it’s during market corrections that the wheat separates from the chaff, among stocks (the best names hold up very well, a sign of sponsorship, while the worst stocks just crater under the weight of the market), but also among investors.

You see, the novice investor sees all of this volatility and thinks, “Gee, I can make a killing by just catching a day or two of movement!”  But in the end, the investor who tries to make a quick buck ends up losing a few quicker bucks in the process.

The intelligent investors tend to sit back and study up on those stocks that are resisting the market’s downtrend, forming constructive, high-probability patterns that they can take advantage of.  They avoid churning their accounts with a lot of trades during this period, instead letting the amateurs try to play that game.  They focus on building Watch Lists and keeping any new buys relatively small until the storm clears.

That’s what I’m aiming to do–take a mental break from trading, but step up my pace of research each day as I look for resilient stocks with powerful growth stories.  Following this game plan helps produce the best results once the market enters into a new sustainable advance.

At this point, of course, all the market has done is bounce.  So my main focus is on finding those stocks that (a) weren’t beheaded during last week’s decline and (b) have rebounded the strongest, and on the best volume, during the past few days.  Surprisingly, many stocks fit my criteria.

There are the usual suspects, like Apple (AAPL), Baidu (BIDU) and Netflix (NFLX), all of which are performing very well.  There are some others, like F5 Networks (FFIV), Salesforce.com (CRM) and VMware (VMW), that have good growth stories and have jumped nicely this week.

But the one I’m highlighting today is a stock few people are watching, mainly because it doesn’t inspire images of huge growth.  In fact, I’m guessing many who read this won’t like the idea!  But I think it has great potential as the construction- and building-related industries begin a huge turnaround.

The stock is Owens Corning (OC).  Seriously!  The company has been around for more than 70 years, and it’s in the midst of a big turnaround thanks to its roofing and composites business.  Here’s what I wrote about the company two weeks ago in Cabot Top Ten Report:

“Owens Corning is another in a growing line of housing- and building-related stocks that’s under strong accumulation as investors begin to see signs of a recovery in the industry. Owens Corning is a big ($5 billion) producer of residential and commercial building materials, including composites, roofing and insulation. And all of those segments are showing healthy activity, with both increased volumes and cost cutting leading to large increases in the bottom line. In the first quarter, sales rose 18% while earnings of 42 cents a share were a whopping 27 cents above expectations. Better yet, management significantly hiked estimates for 2010 to $2 per share, compared to $1.14 last year. There’s nothing revolutionary here, but after cutting costs to the bone, Owens Corning looks set to take full advantage of the global economic boom, which should drive a turnaround in construction levels.”

The stock broke out around 27 in the second week of April and then soared as high as 36 in the weeks that followed.  Then came the brief plunge to 31 during the market’s dive last week.  And how did OC react this week?  It moved right back up to 36!  That’s a strong sign that the buyers are still in control, and are snapping up shares during any weakness.

That said, I don’t think OC is heading significantly higher from here–more likely is a period of backing-and-filling, similar to the overall market.  But to this point, the stock’s recent, powerful breakout, along with its quick snapback from last week’s malaise, puts it on my Watch List.  If you’re aggressive, you could buy a little in the 33-35 area and see what comes.

All the best,

Mike Cintolo

Editor’s Note: If you’d like Mike’s latest opinion on Owens Corning (OC), as well as immediate access to future recommendations of Cabot Top Ten Report, I suggest you take a look here. A new issue comes out every Monday, don’t miss the next one! Click below to learn more.
 
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