An End of Summer Q&A

Hitting the Beach


Another Cisco?

It’s the last week of August, which means a few things. First, volume in the market is drying up as most investors enjoy the last couple of weeks of summer at the beach. Second, my correspondence with subscribers is very low as … they’re also at the beach. (Now that I think of it, why aren’t I at the beach? But I digress.)

But I’ve been saving up many subscriber emails in my inbox during the past couple of months, and I was asked some good questions at our recent Cabot Investors Conference. So I figured now’s as good a time as any for a Q&A covering some common and interesting questions I received during the past couple of months. Consider reading it after you finish your gigantic sand castle. (You know you still like to build them. Admit it.)

OK, on with the show.

Q: I’ve owned Cabot Top Ten Trader stock InterMune (ITMN) for a while, and it was just bought out and soared on the news. I’ve never owned a stock that got bought out—should I sell it? Sell some? Hold through the merger?

A: My general answer for all buyouts is similar: We never look a gift horse in the mouth, so we generally sell on any buyout news. We have seen a few instances where a bidding war erupts with some of these firms; thus, if you want to hold for a week or two to see if some over-the-top bid comes in, that’s fine. What I don’t like is just holding the stock forever—sometimes these deals can fall through (in which case the stock plunges).

What about buyout rumors, where a stock rallies on rumors that it might be bought out? I usually ignore them, unless the ensuing rally trips some sort of sell rule (say, if the stock’s been running for months and then explodes higher, maybe I’ll sell some). But if you buy or sell based on rumors in the market, you’ll be making 25 trades every day. Stick with the facts.

Q: You’ve written two or three pieces in Cabot Market Letter during the past year talking about this possibly being a new secular bull market. What are your latest thoughts?

A: I could write a whole Cabot Wealth Advisory about this, but basically, this subscriber is referring to the fact that it’s possible the big 2000-2012 sideways phase in the market (when the S&P 500 couldn’t get above 1,570 or so) is over, leading to a 12- to 20-year general uptrend in the market.

In early 2013, my answer was generally no, I didn’t believe we had decisively entered a new secular bull market, but as time has passed, my view has changed. When August ends, the S&P 500 will have traded completely above its old high for 14 months. That, to me, is a decisive breakout and follow-through on a long-term chart.

On the flip side, we’re seeing a bunch of late-stage action right now (divergences and the like that typically come toward the end of bull cycles), and the Nasdaq, which was the key index that kicked off the bear market in 2000, is still well shy of its old highs. In fact, it continues to trace out a pattern very similar to the Dow from 1929 to 1949 or so.

This is one of those questions that won’t be fully answered for another few years. But, if I had to bet today, I would say yes—I do believe the secular bear cycle from 2000-2012 has ended, and we’re now in a multi-year uptrend (with periodic 10% to 25% corrections along the way).

Q: Is it worth holding through earnings? I’ve taken a bunch of big hits during the summer.

A: Yes, for many growth stocks, the second quarter (July/early August) earnings season wasn’t a good one; many stocks fell 5% to 10% or even more on their reports. It wasn’t the most pleasant time, to say the least.

That said, we take the long view when it comes to earnings reports—we’ve always held our shares through reports, figuring that, over a few years, we’ll have more wins than losses. Plus, if you sell ahead of earnings every time, you’ll never hold a stock for more than a couple of months … and that makes it hard to notch a big winner.

However, my main conviction when it comes to earnings is that you should be consistent, and to live with your decision—if you want to hold through earnings, then do that with all your stocks, and then live with that decision. Don’t hold onto the first two stocks, then sell the next two, then hold the next, etc. The odds are you’ll end up selling the ones that gap up, and holding the ones that gap down!

You can also consider applying some prudent portfolio management rules ahead of earnings. For instance, you might decide to sell one-third of your holdings ahead of earnings if you don’t have a profit of, say, 10% or more. But, again, if you do this, be consistent and follow your rules.

Long story short, it’s no secret that earnings season is something of a crapshoot short-term, but you can survive and even thrive if you follow a well thought-out plan.

Q: You’ve written a good amount about how growth stocks have been mundane this year, so why not dive into value stocks or dividend stocks when they’re working, then switch to growth stocks when they’re working?

A: This came from a subscriber, but I’ve also had this discussion a few times with a friend of mine who ran a small hedge fund. My general answer is that, in the market, the music is always changing—just when you get used to the waltz, the music switches to tango, and then to the foxtrot. Thus, just as you settle in to a value methodology, value stocks stagnate and growth stocks take off, or vice versa.

Now, with that said, you shouldn’t continually ram your head into a brick wall if the environment is challenging. But instead of completely switching back and forth between methodologies, consider tweaking things. For instance, if growth stocks aren’t trending too well, consider booking partial profits relatively quickly. Or consider sticking with bigger, less volatile names to reduce your risk.

If you have a couple of different portfolios that track different methodologies, and want to slightly emphasize one over the other at certain times, that’s fine. I know of many subscribers who do that successfully. My main point is that no system works 100% of the time, so completely switching hats can often do more harm than good.

Q: I know you guys stick with what the market is doing, but don’t you have to factor in the Iraq/Gaza/Ukraine/China/Federal Reserve actions into your thinking? Can’t any one of these things cause the market to drop precipitously if something goes wrong?

A: In the short-term, yes, any “shock” event can take the market down. But major tops almost always take time to build, and the reason is simple—big institutional investors take time to distribute their “overvalued” stocks. And, just as important, it takes time for psychology to change enough to move from bull to bear.

Market-wise, nearly every top through history has shown common characteristics like divergences, expansion in the number of stocks hitting new lows (often while the indexes are near their bull market peaks) and some major breakdowns among a few key institutional-quality leading stocks. That’s what our indicators are generally focused on.

If you’re a short-term trader, sure, any news event can hurt you, and maybe you have to factor that into your thinking. But, usually, it’s the thing that few people are watching or paying attention to that affects the market—the major hotspots of the world are well covered and often already discounted by stocks. That’s why we prefer to simply follow the market itself.

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Speaking of the market itself, what you should sit up and pay attention to is the unusual—i.e., a huge-volume earnings gap or major breakdown on good news, etc. Stuff like that can often signal a sudden, but lasting, change in perception.

That’s what I’m thinking could be going on now in the general market. Four weeks ago, the market had just gone through a choppy distribution phase, with the major indexes gyrating up and down for a few weeks. Then came the huge-volume breakdown, and a big expansion in the number of stocks actually hitting new 52-week lows even as the Dow was just off its all-time high. And, bigger picture, some small-cap indexes diverged badly from the more popular Dow and S&P 500.

In other words, the stage was set for a decline, possibly a good-sized one that would lead us to the first “real” correction in over a year.

Such action would have been expected. But instead, after a week of falling futher, the market turned tail and began to rally. And it hasn’t stopped! Granted, as I mentioned earlier, it’s late August, so many of the key players are likely working on their suntans. And we still have some of the aforementioned yellow flags (divergences, etc.). But the action is surprising, and the fact that it’s kept going makes me optimistic.

Moreover, growth stocks—most of which didn’t really get going during the May-June rally—are acting better and many have etched six month launching pads. One that I’ve been following hasn’t been consolidating for that long … but only because it just came public in early June! It’s Arista Networks (ANET), and here’s what I wrote about it in Cabot Top Ten Trader two weeks ago:

“Arista Networks has a story straight out of 1999, when the buildout of the Internet’s infrastructure was all the rage. In the networking world these days, the focus is on firms that have specialized data switches and software that help enable cloud computing, and Arista looks like a new leader in that respect—its products allow networks to be easily managed and quickly integrate apps and customized features. And that, in turn, lowers costs for large Internet companies and cloud service providers. Business has been growing rapidly, and the recent quarterly report confirmed that Arista remains in hypergrowth mode—not only did revenues grow 65% but earnings soared 95%, crushing expectations as profit margins exploded to 17.2%. Moreover, the company continues to broaden its customer base, adding another 200 customers to bring its total to 2,700. (Microsoft has historically accounted for 20%-plus of revenues but that should decrease as Arista expands.) Bottom line, Arista has best-in-class products and top-notch partnerships (it’s worked closely with VMware for years) that are taking share from the big players in the industry, including Cisco. There’s risk here, but if everything falls right, it could go very far.”

Shares rallied to 80 during their initial post-IPO surge and spent nearly eight weeks in a volatile consolidation. But this week, it lifted to the upside! We can’t say it’s completely free and clear of all resistance, and ANET is sure to be a hot potato, so keep your position size relatively small. But I think it could be nibbled at here, with the idea of adding a little more from time to time if the stock continues higher.


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