Perceptions and Reactions

by Michael Cintolo on April 29, 2010
originally from Cabot Wealth Advisory
"There is Nothing Either Good or Bad, but Thinking Makes it So."

Plan Your Trade and Trade Your Plan

Keep Your Eye on this Retailing Stock

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It's earnings season, and that means every day there are stocks gapping up or down following their quarterly reports and conference calls.  Most days, at least one of our recommendations in one of our various newsletters is gapping up or down from the opening bell.

In almost every case, the company we're following will have met or exceeded the official analyst's estimates for sales and earnings.  And the forecast is usually pretty good, too.  Yet despite this "good" news, the stock can often tumble a few percent, and in a few cases, fall much more, breaking through key support.

Whenever this occurs, I am usually inundated with emails asking "Why is the stock down when the numbers were so good!"  My usual answer is simply, "Expectations were higher than what the company delivered."  But I should probably also say, "It doesn't really matter WHY the stock is down; the fact that it's down is all you need to know."

Said another way, it's not the news, it's the REACTION to the news that counts.  That goes for earnings reports, but also to any headline news in the stock market.  News is only "good" if it results in upward price movement.  

If a company comes out with stupendous earnings results and a glittering forecast, yet the stock falls sharply, it's telling you that either (a) expectations for the company were even higher, and thus the stock had priced in better results, or (b) something is wrong with the general market, assuming the stock in question is a true market leader.  (For instance, if Apple (AAPL) and Baidu (BIDU) both gapped below their 50-day lines on earnings, you'd know the market is not on sound footing.)

The whole how-a-stock-reacts-to-earnings game reminds me of the famous quote from Hamlet:  "There is nothing either good or bad, but thinking makes it so."  In the stock market, the way to tell what people are thinking is simple ... you watch the stock's price and volume action.  

Nicholas Darvas, author of "How I Made Two Million Dollars in the Stock Market" (one of my favorites), used to talk about how, when he was on the road, he'd get a copy of Barron's, throw away all the news and opinion, and keep only the stock tables.  He was focused on the actions of the stocks themselves, not the news!

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So does that mean you should bail on every stock that falls a few percent on earnings, while buying anything that rallies, regardless of the report?  Of course not.  Like everything in the stock market, perspective is vital.  So you need to know whether the stock's action is abnormal, or simply part of its normal trading pattern.

To determine that you need some chart-reading ability.  But more than that, you need a plan ... something that tells you ahead of time (that is key!) where you'll sell a stock, or for that matter, where you'll buy more.

In fact, a common saying among disciplined investors is that you need to plan your trade and trade your plan.  Translation:  Think about what stocks you want to buy or sell, and at what levels (or because of what activity) you want to buy or sell them.  Write those levels or activity down.  For instance, you might decide to buy XYZ stock if it breaks above the 55 level, or if it rallies 4% on any day on big volume.

Importantly, you want to do all of this while the market is closed, when prices aren't changing and news (there's that word again) isn't flying fast and furiously.  Taking an hour or so on the weekend, or late one night when the kids are asleep, allows you to focus on the charts and calmly digest the situation.  That's when the best decisions are made.

Then you take your plan and follow it the next day or week ... yes, regardless of how you feel or what someone else tells you about a stock's action during the day.  You follow the plan.  That's what it's there for!

It's not all that different than a game plan in football; the team that prepares the best during the week and executes their plan the best on Sunday is usually the victor.  And the trader or investor who's prepared for all the possible contingencies--what you'll do if your stocks go up, down, if the market breaks down, etc.--is the one who, at the end of the year, usually makes the most money.

I'll leave you with one last thought.  A trader I listened to a few months ago said that nobody can predict what's going to happen in the market with any consistency.  But the best investors make money by thinking ahead of time about what they'll do in a variety of circumstances, that is, they know how to react to any situation that arises.  It's something to remember, especially as market volatility picks up during the current earnings season.

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In my mind, the market today is in something of a rolling consolidation--it began two Fridays ago when the news broke that Goldman was being indicted by the SEC on fraud charges.  The major indexes took a hit, but rallied back ... before succumbing to some renewed selling pressure early this week.

Overall, this is still a strong bull market, but I do think some more potholes are ahead, at least for individual stocks.  Whereas the major indexes might pull back 2% to 5%, many leaders can drop 10% or more, especially with earnings reports flying around.

My thought is this:  If you can identify a market leader that's pulled back normally to its 50-day moving average, it should be bought.  Then keep a relatively tight 10% loss limit on the shares, so if they truly break down, you'll be out without any major pain. Usually, if bought near the 50-day line, it'll lead to further advances.

One stock I'm watching for just such a scenario is Lululemon Athetica (LULU), which I highlighted in Cabot Market Letter last week.  Here's some of what I wrote:

"One unique and fast-growing new retailing idea out there today is Lululemon Athetica (LULU), a small company with just 130 stores that sells yoga-inspired workout gear.  Admittedly, to some observers the goods seem like high-priced sweatpants, but the company is growing fast for a few reasons.

"First, Lululemon caters mainly to women, a segment that's been overlooked to some extent by traditional retailers.  Second, the quality of its clothes is top notch; most last a long time and feature special fabrics that wick away moisture and move snugly with the body.  Third, and possibly most important, much of its gear blurs the line between fashionable and casual wear--many customers wear their products around the house or for quick errands out of the house because of the comfort.

"For the investor, the main attraction is the company's growth potential.  Management believes 300 stores is doable, and then there's the company's e-commerce business!  Also exciting is the fact that, on average, its stores in the U.S. are just two years old ... leaving plenty of room to boost sales as awareness grows."

Revenue growth is accelerating, and after a massive advance (fueled partly by its own earnings report on March 25), LULU has pulled back from 45 to 39 and change; the 50-day line is a little above 37 and rising gradually.  Ideally the stock will settle down around here, or possibly a little lower, offering a good buying opportunity in the upper 30s.  Watch for it.

All the best,

Michael Cintolo
For Cabot Wealth Advisory

Editor's Note: Michael Cintolo is the editor of Cabot Market Letter, which as been uncovering stock market leaders since the 1970s, like American Medical Systems back in the late 1970s: up 1,097%, or Triangle Industries: up more than 150% in the late 1980s, or Yahoo!, Amazon.com and more in the late 1990s! And Mike is using Cabot's time-tested market timing and growth stock picking system to select the very best stocks of this bull market, like Lululemon Athletica (LULU). Don't miss another issue! Subscribe today.

http://www.cabot.net/info/cml/cmlkb02.aspx?source=wc01

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