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A Barrage of Bad News

The market has been inundated with bad news lately, but so far, the indexes are holding up relatively well, and we’re pleased to see the selling pressures on the broad market ease. (Our Two-Second Indicator is positive again.) We continue to believe the next major move will be up.

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A Barrage of Bad News

The failure of a key health care bill in Congress. Administration scandals in Washington, D.C. Much worse-than-expected car sales and job growth in March. News that the Fed is aiming to reduce its balance sheet and continue hiking interest rates this year. Reports that a tax cut bill will be delayed, possibly until year-end. Missile strikes in Syria, along with the accompanying saber rattling from Russia. A growing U.S. Navy presence near the Korean peninsula to pressure North Korea. And today, more talk of a border tax.

When it comes to the news, the market has had everything but the kitchen sink thrown at it during the past few weeks. Every day brings another worry, another uncertainty, another reason to think the market’s next big move will be down. And investors are responding—during the past three weeks, $19.3 billion has been yanked out of domestic equity funds, while $31.9 billion has poured into the safety of bond funds.

Yet how has the market reacted to these headlines? Not badly at all! The major indexes are all 2% to 4% off their peaks, some leading growth stocks have actually moved to new highs and our Two-Second Indicator has returned to health, indicating that selling pressures are actually easing.

Granted, it’s hardly been a party in recent weeks, with no net progress from even the strongest major index (Nasdaq) and rotation knocking down some stocks and sectors. Our Cabot Tides remain on the fence, and until they return to the bullish camp, there’s still a good chance we’ll get another near-term retreat. Because of that, we’re stepping lightly.

But the current environment reminds us a lot of an old saying—“when the market doesn’t go down on bad news, it’s good news.” Said another way, it’s not the news that counts, but the market’s reaction to that news that counts. So far, the reaction has been very encouraging, especially given the run we’ve seen since the U.S. election.

All told, then, our stance hasn’t changed. Near-term, the outlook is a bit of a tossup, which is why we’re going slow. But longer-term, the evidence (longer-term uptrend, 7.5% Rule, etc.) continues to tell us the next major move is up—and the market’s stubborn action of late reinforces that thought.

[highlight_box]WHAT TO DO NOW: Remain optimistic but keep some powder dry until the bulls return. In the Model Portfolio, we’re rotating out of losers and holding some cash, but also doing some selective new buying. Last night, we sold Lumentum (LITE), but tonight, we’re replacing it with Alibaba (BABA), leaving us with around 29% in cash.[/highlight_box]

Model Portfolio Update

With the market stuck in a tight trading range, we’ve been mostly biding our time in recent weeks, holding some cash and giving our stocks room to breathe. But we’ve also been following the market’s lead when it comes to the action of individual stocks—we’ve rotated out of our losers in recent weeks, including our sale of Lumentum on a Special Bulletin last evening.

However, with the odds favoring the next major market move being up, and with many growth stocks still acting well, we’re also open to selectively adding stocks that could lead the next market upturn. On that note, tonight we’re replacing LITE with Alibaba (BABA), which is showing signs of emerging.

That will still leave the portfolio with around 30% in cash, offering a cushion from any further short-term market issues, as well as buying power to put to work once the bulls return.

Current Recommendations

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BUY—Alibaba (BABA 111)—Fundamentally, we’ve always thought Alibaba has years of rapid growth ahead thanks to its leading position in China’s e-commerce boom (as well as its expanding presence globally). Indeed, in the fourth quarter, local currency sales rose 54%, earnings rose 30% and free cash flow boomed to $4.9 billion (more than $1.90 per share), which was well above net income and up 44% from a year ago. Beyond commerce, Alibaba’s cloud division has all the potential of Amazon a few years ago; it’s only 3.3% of revenues, but is growing at triple-digit rates and should start contributing to earnings in a couple of quarters. As for the chart, BABA has been pushing higher in recent weeks despite the choppy environment, and if and when the market’s longer-term uptrend resumes, the stock looks poised to be a leader. One note: Earnings are likely due out in a couple of weeks, which is an added risk, so you could consider buying a smaller than normal position. But as usual, we’ll keep it simple and buy our normal-sized position tomorrow.

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BUY—Facebook (FB 140)—Facebook remains on an excellent growth track; the company announced this week that it has five million active advertisers, up from four million just six months ago. The firm also said 65 million businesses now have mobile pages and eight million have Instagram profiles. On the competitive front, Facebook is still taking aim at Snapchat by copying some of its most popular features—Instagram Direct allows users to send a photo or video that will vanish soon after being viewed; 375 million people are now using this feature, up 25% since November. Of course, the real key will be how all of that translated into the company’s bottom line—Facebook’s earnings will be released on May 3, and analysts are looking for both sales and earnings to rise 45% from a year ago. The stock has pulled back after a persistent advance, approaching its 50-day line. A clear breakdown would have us moving to Hold, but right now, this dip (its first of the year) looks buyable.

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SOLD—Lumentum (LITE 44)—LITE closed below our mental stop (and its 50-day line) yesterday, spurring us to cut our loss. We knew that optical networking stocks could be volatile, but LITE and its peers have run into trouble lately on fears that the spending cycle could soften. Whatever the reason, LITE isn’t nearly as resilient as many other growth stocks, so we sold it on a Special Bulletin yesterday and we’re redeploying the cash in BABA. (see page 2).

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HOLD—Netflix (NFLX 144)—The S&P 500 hasn’t made any net progress since mid-February, so it’s not surprising to us that NFLX is in the same boat, with the stock hovering in a very tight range (138 to 148) for the past two months. The big event will come next Monday evening (April 17), when the firm will release earnings; analysts are expecting 35% revenue growth and a 517% boom in earnings, to 37 cents per share. However, just as important will be the outlook, including whether management’s new balanced tone (wanting to grow, but also wanting to crank out increasing profits) still holds. We’re optimistic that the company has only just begun a sustained upturn in its bottom line, which will keep big investors interested, but we’ll stay on Hold and see how the stock reacts to earnings next week.

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BUY—ProShares Ultra S&P 500 Fund (SSO 84)—We’re sticking with a mental stop on SSO in the 82 area for one-third of our shares—above that level, it appears the overall intermediate-term uptrend is intact, but below it could bring a more protracted decline. Longer-term, of course, we’re far more optimistic, which is why our goal is to hang onto most of our shares as this bigger-picture bull market plays out. As for the here and now, SSO continues to gyrate around its 50-day line and is just three points from all-time highs, so if you want to pick up a few shares, you can.

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HOLD—Shopify (SHOP 69)—We decided to take partial profits in SHOP two weeks ago, when the stock suffered its second giant-volume selling day in a week. However, as we write on page 6, taking some chips off the table in a situation like this is more about giving us staying power to try to ride out a larger move. Should the worst occur (SHOP implodes going forward), at least we made some money on the partial sale (about 1.2% of the portfolio’s value), but the goal is now to give our remaining shares room to maneuver and possibly score a big winner that can make a real difference in the portfolio. Back to the stock itself, it’s holding up well, and if it resumes its uptrend, we could go back to Buy. But for now, the sideways market environment and the recent big-volume selling have us sticking with a Hold rating.

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BUY—Veeva Systems (VEEV 50)—Like most stocks that lifted above resistance in recent weeks, VEEV has met with selling pressure in recent days, though the damage has been minor, with shares still above their prior peak of 48 and their 25-day line. The company has been quiet on the news front since announcing a deeper integration of its software into Salesforce.com’s suite of products, and that silence is likely to continue, as the next earnings report isn’t due until early June. While further weakness is possible if the market slides, we think VEEV can lead the next upturn due to its great story, excellent growth and the fact that the stock just got going after six months of no progress. Hold on if you own some, and if you don’t, you can buy around here.

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HOLD—XPO Logistics (XPO 46)—XPO will release its quarterly report on May 4, which we think has a chance to re-attract buyers—remember, XPO’s story revolves around its surging free cash flow, which has far more to do with its own efficiency initiatives than the state of the transportation sector as a whole. (Transports remain among the weakest groups). That said, we’re going to play it by the book and simply let the stock tell us what to do—should XPO close decisively below 45, we’ll pull up our stakes and move on. Otherwise, we’ll sit tight and give the stock a chance to continue to pull out of its correction.

Watch List

Arista Networks (ANET 132): Not many investors know of ANET, but it continues to hold up extremely well, and it got some good news recently on the legal front versus Cisco.

Pulte Homes (PHM 24): Pulte remains in a very tight trading range, which is usually a sign of accumulation after its recent move higher. We think PHM and many homebuilders could surprise on the upside. Earnings are due out April 25.

Square (SQ 17): SQ is trading a bit wide-and-loose, which isn’t ideal, but the overall consolidation in recent weeks is reasonable. Fundamentally, we think its market potential is larger than many investors appreciate.

Tesla (TSLA 297): TSLA has soared to all-time highs in recent days, a very bullish move following years of consolidation. Production growth remains rapid, and Model 3 deliveries should start later this year.

Universal Display (OLED 82): OLED is very volatile on a day-to-day basis, but remains in a reasonable trading range since its February surge. The upside potential appears to be huge if things go right.

Vertex Pharmaceuticals (VRTX 115): VRTX is a leader in cystic fibrosis treatments, and a recent positive study of one of its drugs catapulted the stock higher. See page 6 for more.

Other Stocks of Interest

The stocks below may not be followed in Cabot Growth Investor on a regular basis. They’re intended to present you with ideas for additional investment beyond the Model Portfolio. For our current ratings on these stocks, see Updates on Other Stocks of Interest on the subscriber website or email mike@cabotwealth.com.

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Chipotle Mexican Grill (CMG 458) — CMG is a poster child for what bad publicity can do to a company. Chipotle was working on a 14-year string of double digit revenue growth when disaster struck. A string of customer illnesses caused by contaminated produce toppled the company from its perch as a fresh/local/organic ingredients paragon. CMG, which was trading at 759 in August 2015, fell to 353 in November 2016, as earnings dropped from $15.10 in 2015 to $1.32 in 2016. It has taken a long time for CMG to work through its bottoming process, but it may be starting to turn the corner. The stock is back up to 453 after a sharp rally in late March. Earnings are out later this month, and a good report could finally produce a lasting rally in this fallen angel. It’s too early for us, but it’s worth keeping an eye on.

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KB Home (KBH 20) — The real estate market in the U.S. is benefiting from low mortgage rates, optimism about the economy and a restricted supply of homes to buy. KB Home is a homebuilder that concentrates operations in the strong southern region (Florida, South Carolina and Texas) and the west (California, Colorado, Arizona and Nevada). Homebuilding activity still has a long way to go to get back to its historic averages, and KB’s mix of single-family homes, townhouses and condos pushed revenue up by 19% in 2016 and 21% in each of the last two quarters. Analysts see earnings soaring 42% this year and 21% next year and management sees no threat to the company’s string of 20 consecutive quarters of year-over-year increases in net order value. The company has total liquidity of $596 million, which cushions financing costs. LBH popped out of a two-month base in February and looks great.

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SiteOne Landscape Supply (SITE 47) — SiteOne is a very conventional landscaping company in one way: It sells irrigation supplies, fertilizers and bug/weed controls plus pavers, stones and blocks. Where it differs from your local landscaper is that SiteOne has gone national, and is rolling up smaller landscape firms into a national distributor—483 stores in 45 states offering 100,000 products to both individuals and professionals. Last year, the company gobbled up six firms, which added $150 million to its annual revenue. SiteOne has only a 10% market share nationally, but that’s four times bigger than its nearest competitor. SITE soared from 32 last December to 50 on April 5 and its small pullback looks buyable. The stock is thinly traded, which will probably keep it out of the Model Portfolio, but a buy on dips could work out well.

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Vertex Pharmaceuticals (VRTX 115) — Vertex Pharmaceuticals has long been on the list of pharmaceuticals with big potential, but it looks like it might be ready to step up into the big leagues. Last year, Vertex won approval for three of its treatments for cystic fibrosis (CF). Then, on March 29, news broke that a Phase III clinical study of a new combo therapy for CF that included one of Vertex’s candidates had shown big improvement in lung function for patients over 12 years old with certain conditions. VRTX popped from 90 to 108 on the news. And with earnings forecasts at 90% growth for each of the next two years, VRTX may have a long way to run.

Developing Staying Power—And Big Winners

One of the bedrock principles of growth investing is to keep all losses small while working to develop bigger winners. In terms of planning, cutting losses is easy—you simply have to adhere to a reasonable loss limit and pull the trigger if your stock gets there.

We’ve had to do that a few times this year as some sectors (like commodities and financials) hit major potholes and as the rally has thinned out. But the good part about cutting those losses is that they don’t do much damage to your overall portfolio—our sales of Callon Petroleum, PayPal, Martin Marietta, Freeport-McMoRan, Texas Capital and Charles Schwab weren’t fun, but combined, they cost the Model Portfolio about 3.4% of its total value. (We’d note that, on balance, the losses would be larger today if we hadn’t sold because a couple of the stocks hit the skids after we exited.)

That’s not “good,” but it’s easily made up with a couple of decent winners. Our open profits in both the ProShares Ultra S&P 500 Fund and Facebook are both larger than those six losers combined. So is Shopify if you include the partial profits we booked two weeks ago.

Thus, cutting losers is vital and somewhat mechanical. But what about developing winners? That’s a harder task—give a winner too little room and you’ll get knocked out on a normal pullback, but give a winner too much room and you could give up most of your profits … and watch your portfolio take a big hit, too.

Over the years, we’ve found that a good way to deal with this “problem” (handling winners is a good problem to have) is to take partial profits on the way up. By booking some profits and reducing your position size slightly, you’ll have more leeway to give your remaining shares room to correct, consolidate and base-build, which all big winners do during their advances.

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Facebook has been a good example. We originally recommended the stock in July 2013 at 38, and except for one 25% correction that we sat through, it was a relatively smooth ride higher during the next year. But as the market sagged and FB stalled out a bit, we sold one-third of our shares in October 2014. We sold one-third of our remaining shares in August 2015 as the market had a mini-crash and as the stock briefly dove below its 200-day line. And we sold another third (again, of our remaining shares) last November when FB again dipped below its 200-day line and growth stocks looked horrible.

Obviously, from today’s perspective, it would have been nice to have never sold a single share. But how likely is it that we would have been able to hold on through the numerous dips below long-term support and multi-month sideways periods if we had a quarter or more of the Model Portfolio in the stock? Not very! Lightening the load occasionally on the way up can actually help you make more money than just trying to sit tight through all of a stock’s retreats. (We’ve already taken profits equal to our initial investment in FB and have a good-sized position still on the books; the overall trade has boosted the portfolio by 18%.)

Obviously, not every stock will advance like FB has, but that’s our hope with Shopify (SHOP). We took partial profits in SHOP two weeks ago after it suffered a couple of bouts of distribution. With some profits booked, we’re going to give our remaining shares plenty of rope to consolidate and correct, thinking that SHOP has a chance to be a big winner as the current bull market matures.

The bottom line is that taking a few chips off the table on the way up is a good method to create staying power, which is necessary if you’re going to develop the big winners that make all the difference in your returns.

Alibaba (BABA): Ready at Last?

We’ve been following Alibaba since it came public, and even bought it a couple of times—though we have little to show for it. But we have always believed that, eventually, the stock would be a liquid leader because of its one-of-a-kind growth story. And it’s looking more and more like that time could be now.

The stock has formed a gigantic post-IPO base during the past two and a half years, which includes a six-month base that started last September. This week, shares tagged two-year price highs while the RP line gained ground. Earnings are likely coming out in two or three weeks, but we’re adding it to the Model Portfolio tonight, thinking the stock will healp lead the next market upmove. BUY.

Cabot Market Timing Indicators

Our outlook is relatively straightforward: Long-term, we’re bullish, bolstered by the market’s major uptrend, some bullish studies and an improving broad market. But with the intermediate-term trend still neutral and few stocks hitting new highs, it’s best to go slow and wait for the buyers to return.

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Cabot Trend Lines: Bullish
The market’s six-week consolidation hasn’t altered our Cabot Trend Lines, which remain solidly bullish, as both the S&P 500 (by 5.2%) and Nasdaq (by 7.4%) stand well above their respective 35-week moving averages. Thus, the long-term trend remains clearly up, and combined with some other studies (like our 7.5% Rule that we wrote about in the last issue), the odds strongly favor higher prices down the road.

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Cabot Tides: On the Fence

The intermediate-term outlook, though, is more of a coin flip. Our Cabot Tides are still on the fence, as four of the five indexes we track (including the S&P 400 MidCap, shown here) are sitting just above or just below their 50-day moving averages. Until we see the buyers return, it’s a reason to keep at least some of your powder dry.

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Two-Second Indicator: Healthy

The Two-Second Indicator has been a major bright spot during the past two weeks, with the number of new lows coming in below 40 in each of the past 12 trading days. Thus, while the market is meandering, the selling pressures on the broad market are drying up, which bodes well.

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All Cabot Growth Investor’s buy and sell recommendations are made in issues or updates and posted on the Cabot subscribers’ website. Sell recommendations may also be sent to subscribers as special bulletins via email and the recorded telephone hotline. To calculate the performance of the portfolio, Cabot “buys” and “sells” at the midpoint of the high and low prices of the stock on the day following the recommendation. Cabot’s policy is to sell any stock that shows a loss of 20% in a bull market (15% in a bear market) from our original buy price, calculated using the current closing (not intra-day) price. Subscribers should apply loss limits based on their own personal purchase prices.
Charts show both the stock’s recent trading history and its relative performance (RP) line, which shows you how the stock is performing relative to the S&P 500, a broad-based index. In the ideal case, the stock and its RP line advance in unison. Both tools are key in determining whether to hold or sell.

THE NEXT CABOT GROWTH INVESTOR WILL BE PUBLISHED APRIL 26, 2017

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