I started working at Cabot in June of 1999 (nearly 18 years ago—whew!), smack dab in the middle of the Internet bubble. Those were heady times! And I don’t mean just the action in the stock market, but also the enthusiasm among so many individual investors. It seemed like everyone was buying stocks.
I distinctly remember the time when a UPS delivery man, who used to drop off packages at our office two or three times a week, saw our whiteboard of stocks we had in the Model Portfolio of Cabot Growth Investor. Carlton Lutts, our founder, happened to be strolling by; I really don’t remember exactly how the conversation started, but I do remember that it went on for about 15 minutes, with the driver telling Carlton that he owned some of the stocks we had, how he bought them before us and bought more on dips, and shared a smaller name or two that he really liked.
Now, I have nothing against UPS delivery men or women, and I hope more people learn how to properly invest. That’s the business I’m in after all! But my point is that back then, everyone was (or wanted to be) buying stocks! And, of course, a major market peak followed—so major that the S&P 500 didn’t decisively top it for another 13 years, and the Nasdaq for 16 years.
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In recent months, of course, the major indexes have lifted to new all-time highs, with the Dow topping 20,000 for the first time ever and the Nasdaq leaping above 6,000. Yet sentiment among investors couldn’t be more different. As I mentioned in my last column, far more money continues to pour into bonds than stocks, and as of two weeks ago, just one-quarter of individual investors described themselves as bullish.
I think these worrywarts are making a big mistake. So today, I’m diving into another one of our proprietary market indicators (one I’ve been writing about in Cabot Growth Investor) that’s telling us the odds strongly favor higher prices down the road.
Buying Stocks: The 7.5% Rule
The indicator is called the 7.5% Rule and it’s very easy to understand: When the S&P 500 closes a week at least 7.5% above its 35-week moving average for the first time in at least nine months, it’s a Buy signal. The theory is that when the stock market gets this overbought for the first time in a while, it’s a sign of market momentum—and that momentum tends to continue.
Since 1980, the 7.5% Rule has flashed 10 times, or about once every three and a half years. On average, the S&P 500 was 5.0% higher three months later, up 9.2% six months later and up 15.4% a year later. Better yet, during the year following the signal, the market rose as much as 21.2% from the signal to its peak. Not too shabby.
Perhaps more impressive is that these signals rarely led to much downside. Only one instance (the Buy signal in 2006) saw a loss in the S&P 500 after three months; six and 12 months later, every single signal produced a positive return! Moreover, the S&P 500 faced a maximum loss of just 2.5% from its Buy signal during the following year. That’s very tame compared to the gains that were produced.
The most recent signal came on February 27 when the S&P 500 was at 2,383. So far, the signal is off to a slow start (the index is up just a smidge since the signal), but the index’s biggest loss from that signal was 2.5%—in line with the average result.
Conclusion: Some further wiggles are possible in the weeks ahead, but if history is any guide, the 7.5% Rule tells us the market has plenty of upside as 2017 progresses. Which means that unlike in 1999, buying stocks is actually a good idea.
The Next Big Stock Winner
Thus, instead of waiting for a shoe to drop, I believe investors should be looking for the next big winner. One name I’m watching is Autodesk (ADSK), which I wrote about in Cabot Top Ten Trader a couple of weeks ago. Here’s what I wrote:
“Take a look at recent sales and earnings figures and it appears that Autodesk—the leading provider of computer-aided design software—is struggling mightily, with sales falling off a cliff and the bottom line mired in the red. But business is actually doing great! The company is in a transition to a subscription-based business model and away from product licenses; prices have come down but, over time, business will rise as subscriber totals and renewal rates increase. (Revenues are dipping as sales are recognized over time, not when a subscription begins.) That’s what’s happening now. In the most recent quarter, Autodesk’s “new model” subscriptions rose 26% from the prior quarter, while new model annualized recurring revenue was $529 million (up 107% from the year before) and deferred revenue grew 18%. The end result is that the company’s earnings power is increasing, which is why big investors have been picking up shares—long-term, the business model transition should create tons of cash flow (management is targeting $6 of free cash flow in 2020). Institutions have seen a similar story play out bullishly with Adobe Systems, and are thinking Autodesk is in the early stages of a similar move. Along with its dominant position in the industry, Autodesk has solid potential.”
The stock recently consolidated with the market for a couple of months before shooting to new highs. The only trick here is that earnings are due out May 18, so if you decide to take a stab at ADSK, I advise keeping positions relatively small ahead of earnings.
P.S. If you’re on Twitter, give me a follow @MikeCintolo. I usually Tweet out few tidbits each day on what I’m seeing in the market and individual stocks, including the occasional set-up. It’s free, so follow along!