I want to cover three things today: (1) possible reasons behind the stock market swoon, (2) what to expect over the next couple of months, and (3) what opportunities to look for both within and beyond our current portfolio.
First, what’s behind the stock market’s precipitous decline?
Three things, starting with the rapid move higher last week in treasury yields. That matters because yields are getting up there (interest rates on 30-year mortgages are now around 5%), which could put pressure on both the U.S. economy and corporate access to credit. It also could put downward pressure on stock valuations since these higher interest rates are currently being plugged into analysts’ financial models (mainly discounted cash flow models), which will result in lower price targets (due to the discounting of future cash flows back to the present at a higher rate).
The second reason for the market decline is the escalating trade war with China. Last week JP Morgan stated that a full-blown trade war is their new base case and that they’re factoring in a 25% tariff on all Chinese goods. Dr. Ed Yardeni had an interesting take on this trade war; he now asserts that the Trump administration’s policies are “aimed at either slowing or halting China’s drive to become a superpower. He [Trump] wants to reduce America’s huge trade deficit with China by forcing U.S. and other manufacturers to move out of that country. In the process, the U.S. would no longer be financing China’s ascent with our trade deficit and providing technological know-how that has been either stolen or extorted.”
The Bloomberg Businessweek cover story stating that Chinese spies attacked almost 30 U.S. companies (among them, Amazon and Apple, who have both denied the claims), and inserted tiny microchips into motherboards designed for spying, feeds into this storyline quite well.
The third likely reason for the market decline is that stocks had come further than most market observers had expected this year and that there are concerns that valuations and profit margins have peaked. That alone could validate a reset. In hindsight it’s not surprising that the market had a visceral reaction to all of the above coming together at the same time.
So, what do we look for over the next couple of months?
Earnings season starts in earnest today and this is a big deal. On the short list we want to keep an ear open for management commentary around tariff impacts, interest rate hikes, end-market demand dynamics, stock buybacks and M&A. We also want to listen to what the analyst community has to say about all of the above as their analysis is likely to drive the crowd.
On the market, for the bull market to stay intact, we want to see some stabilization followed by a period of digestion as market participants come to terms with the aforementioned reasons for this decline. I don’t think a vee-shaped recovery would necessarily be a good thing as, in my mind, the rapid rise in interest rates alone will have widespread impacts on everything from consumer spending and sentiment to corporate decision making. The impact of that potential will take some time to work its way through. We could easily bounce around for several months while the market digests.
The looming question: Is the U.S. economy strong enough to withstand higher interest rates and a trade war, among everything else that’s going on? We’ll just have to wait and see.
What’s evident now is that most of the market’s year-to-date gains were wiped out as of Thursday’s close …
… and the S&P 600 Small Cap Index is trading just above the zone of resistance that it bounced up against several times earlier in the year, before finally breaking through in early May.
I’ll feel better about turning more bullish if the index can hold around this level and if small caps and growth stocks can stabilize over the next two weeks.
It’s also particularly important that we monitor the moves in software stocks since we have a lot of exposure here still, and because the trend in software stocks broke so severely in October. A decent, but not perfect, proxy for software stocks is the iShares North American Technology Software ETF (IGV). This ETF has 65 stocks across market caps. Here’s what the three-year chart looks like; as you can see it just fell to its 200-day line for the first time in a long time.
Bottom line – I’ll be watching software stocks closely for both signs of another breakdown or that we should move back in.
What opportunities should we look for?
In our current portfolio stocks that are rated buy (but keep new positions small) are Goosehead Insurance (GSHD), Bottomline Technologies (EPAY), Altair Engineering (ALTR) and Arena Pharmaceuticals (ARNA).
I’m also on the lookout for stabilization in our cloud software stocks, especially those that are higher quality names that have received favorable coverage from analysts in the past because of their durable business models. On this list are several that we have taken partial gains on, including Q2 Holdings (QTWO) and AppFolio (APPF). Apptio (APTI) and Everbridge (EVBG) are two more that I’d like to move back into should things firm up.
Beyond our portfolio, a few big-picture trading ideas are:
iShares North American Technology Software ETF (IGV) – As discussed above this ETF gives exposure to software stocks and strips out stock-specific risk. It’s bouncing today and could provide some quick profits if you play it right.
S&P 600 Small Cap Index ETFs – Pick your poison. IJR give you access to growth, IJS to value and IJT to a blend of both. All three ETFs are below their 200-day line and could deliver gains, especially if investors turn more bullish and start to focus on domestically-oriented companies again.
And two SMID (small and mid caps) ideas that I’ve mentioned in the past, but don’t officially cover (you’re on your own if you buy these!):
Inogen (INGN): Inogen makes portable oxygen tanks and has a market cap of $4.3 billion. It’s largely responsible for helping those who need oxygen get out of the house and buy tanks at a much lower cost. It is 30% off its 52-week.
Zendesk (ZEN): Zendesk is a $6.5 billion market cap company that is featured in my Cloud Software Special Report and which sells customer support software. It’s a great company and very well liked by the analyst community. It’s 15% off its 52-week high.
Changes this week (via Special Bulletins):
Instructure (INST) moved to Sell
Apptio (APTI) moved to Sell Half, Hold a Half
AxoGen (AXGN) moved to Sell Half, Hold a Half
Q2 Holdings (QTWO) moved to Sell a Quarter, Hold the Rest
Everbridge (EVBG) moved to Sell a Quarter, Hold the Rest
Updates
Altair Engineering (ALTR) was last Friday’s new addition and the timing of our Issue publication couldn’t have been much worse. The stock pulled back to its July consolidation range (34 to 36) this past week, which is still within a reasonable buy range. Provided you average in to positions (as recommended) you should be in fine shape to add to your position here. Altair sells simulation software. BUY.
AppFolio (APPF) retreated back to its July trading range as well and with any luck should find some support here. The stock remains above its 50-day line, which is a small victory. We’ve taken partial profits so for now just sit on your remaining stake. HOLD a HALF.
Expected Earnings Release Date: Second week in November
Apptio (APTI) tripped our mental stop this week so I sent out a Special Bulletin recommending you take partial profits and hold the rest. It’s one of my favorite stocks in our portfolio because growth is accelerating this year, the company is still led by its founder, it’s addressing a huge market opportunity (helping IT leaders manage their IT spend) and is turning profitable this year. For all those reasons I’d like to move back to buy when the trend stabilizes. But we couldn’t sit idly by and let our gain disappear. For now, just Hold your remaining position. HOLD a HALF.
Earnings Release Date: October 29
Arena Pharmaceuticals (ARNA) sold off following last week’s analyst/R&D day but action was fairly muted this week. That suggests to me that investors realize the company’s assets are quite valuable, even it if will take some time to get them to market. I detailed the developmental game plan last week so I won’t go back into it today. Suffice to say if you are in it for the long haul you can keep picking up shares of Arena here. BUY.
Expected Earnings Release Date: Second week in November
AxoGen (AXGN) inched lower this week, forcing me to send out a Special Bulletin recommending you take partial profits to protect your gain. We notched a gain of 126% from our cost basis, which is far better than the market has performed since I added the stock, but that still feels like a letdown given how high it was before last month’s quarterly report. As I’ve stated several times over the last two months, I’m expecting a good report in Q3 given how bullish management has sounded at conferences in September. With partial profits in the book and a half position still open, we’re positioned to win almost regardless of what the stock’s reaction to the Q3 earnings report is. I expect to hold our remaining position through the earnings report then, based off the results and the stock’s reaction, decide what to do next. HOLD a HALF.
Expected Earnings Release Date: First week in November
Bottomline Technologies (EPAY) dipped below its 50-day line this week but the stock’s decline wasn’t nearly as intense as that of many other stocks. This is a high-quality company with long-term customer contracts so it’s one that investors should be able to hide out in for a while. Keeping at Buy but keep new positions small. BUY.
Expected Earnings Release Date: First week in November
Chefs’ Warehouse (CHEF) surged to a 52-week high last Friday on news it was being added to the S&P 600 Small Cap Index. But that gain, and more, was wiped out this week as selling pressure overwhelmed the stock. Despite the ups and downs in recent weeks Chefs’ is still holding near its 50-day line and is modestly above our entry price. Officially it’s being kept at Hold, but I wouldn’t argue if you want to nibble on a few shares here. HOLD.
Expected Earnings Release Date: Second week in November
Everbridge (EVBG) was holding up relatively well heading into this past week but Wednesday was the straw that broke the stock’s back. A big one-day decline forced me to take protective measures and send out a Special Bulletin recommending you sell a quarter of your position. This is a stock I want to keep a position in for the long haul so I’m willing to hold through some more weakness, but there is a point at which we’ll walk away completely. Shares dipped down to 43 in both July and August, so I’ll be watching that level closely. For now, just Hold. HOLD a FOURTH.
Earnings Release Date: November 5
Goosehead Insurance (GSHD) was our best performing stock over the past week, but that’s a dubious honor. Shares were only down 2%. All things considered the stock is holding up fairly well and is at the high end of the 26-to-29 trading range that persisted for the bulk of the summer. We’re down 10% from our entry price and I’ll keep at Buy. But keep new positions small. BUY.
Instructure (INST) had to be cut loose this week after shares fell below 32 and slightly below our entry price. This one hurts because I think there’s a good chance the stock goes up in the near future. But I’m unwilling to let a gain, even a modest one, turn into a significant loss. So Instructure had to go. I’m not opposed to adding it back to the portfolio, even above our recent exit price, if the trend improves. We have an earnings date of October 29, so I’ll be watching closely. SOLD.
Earnings Release Date: October 29
IntriCon (IIN) was our second “best” performing stock this week as it suffered a decline of only 4%. I’ve been watching the 50 level closely as that’s where I suggested setting a mental stop last week. We’ve dipped slightly below that, but things are looking better today so I’m not recommending any actions right now.
I sent out a Special Bulletin on Wednesday that outlined some of the details of the Bose Hearing Aid. This is the first-ever approval by the U.S. FDA of a hearing aid that allows users to fit, program and control the device on its own. I believe the technology used isn’t all that different from that in many of the hearing aids sold today (many of which feature components made by IntriCon), which suggests that Bose isn’t sitting on any unique technology that would protect its device from competition. In fact, if the technology IntriCon is working on (Sentibo) proves to work it could easily be superior. What all this means is that it appears we’re moving toward a market where hearing aids will be sold over-the-counter (OTC), as we expected. We’re not there yet, and the next hurdle is to see the FDA’s draft regulations for this new category. But by approving the Bose Hearing Aid the FDA has sent a clear signal that things are moving in the right direction.
One final note: the major consumer device manufacturers are all over the smart speaker market. Google, Amazon, Samsung and Apple are all potential market entrants in the OTC hearing aid category, and they all have significant marketing power. It’s too early to say how their entrance would affect the existing oligopoly, but it will be interesting to watch! More to come on all this as the market develops. Right now, just sit on your position. HOLD.
Expected Earnings Release Date: First week in November
Q2 Holdings (QTWO) has historically been one of our most stable software stocks but shares broke below their 200-day line this week and have given up the gains since their breakout move in May. I set a mental stop at 54 last week, so when shares went below that level this week I sent out a Special Bulletin suggesting you sell a quarter position to lock in a 219% gain (from my entry price). I intend to move back into the stock given that Q2 is a high-quality business but I’m not going to make any predictions about the price and market conditions I’d need to see to do so. For now, just hold on to your remaining position. HOLD a FOURTH.
Expected Earnings Release Date: First week in November
Rapid7 (RPD) has been one of the more resilient stocks in our portfolio but it wasn’t able to shrug off the market turmoil. Shares of the cybersecurity stock dipped below their 50-day line on Wednesday. We’re still clinging to a 25% gain but like all stocks Rapid7 is now on a very short leash. I won’t hesitate to take partial profits if the stock falls much below 32 and/or the market doesn’t firm up. It’s noteworthy that security software tends to be a very defensible area of IT spending given the strategic importance of protecting digital assets. Theoretically, this should be good for Rapid7. HOLD.
Earnings Release Date: November 6
