Stick with the Evidence; Ignore the Logic
LEDs: An Idea Whose Time has Come?
It's not often I get a question that actually leads me into two good lessons, but I got one last week that did just that. The specific answer to the question isn't the major takeaway--but I want to use it as an example of why, in the stock market, you should go with evidence, instead of so-called "logic."
Before we get started, let me briefly explain our Two-Second Indicator, which is one of the key market timing indicators I use in Cabot Market Letter. The indicator measures the broad market by taking one simple reading per day (so simple that it takes just two seconds to get)--the number of stocks hitting new 52-week lows on the NYSE.
We've studied the new low data going back to the early 1960s, and as it turns out, when the number of new lows is fewer than 40 day in and day out, the broad market is in generally good shape. Thus, to oversimplify it a bit, fewer than 40 is good, greater than 40 is bad.
Taking it a step further, new lows have always expanded prior to the start of major market declines. The reason: As bull markets mature, fewer and fewer stocks participate on the upside. And by the time the bull is near death, there are just a couple hundred stocks heading higher; the generals leave the troops behind!
Anyway, having studied decades of data, that's what we've found. Now let's get to a good question a subscriber emailed to me a little more than a week ago:
Question: "Mike, because the market's had such a big advance from its March low, with (as you say) most every stock and sector participating, won't your Two-Second Indicator naturally take a long time to turn negative (i.e., have new lows greater than 40)? And, thus, if the market falls from here, you might be stuck being bullish most of the way down?"
My answer: "First off, realize that the Two-Second Indicator isn't the be-all and end-all of our market timing system. In fact, the trend-following Cabot Tides are just as, if not more, important.
"However, specifically when it comes to the Two-Second Indicator, we're just going with evidence--we've had big bear markets before (think 1987, 1974, 2001-2002, etc.) and through them all, when you get a market decline that gets underway for a week or two, yet the new lows are tiny, it tells you that there hasn't been the type of marked divergence that always precedes major market tops.
"In fact, almost every time, that pullback arrests itself fairly quickly. Not always, but very often.
"That's why we think the evidence shows that what we have today is a pullback within an ongoing bull trend. This pullback could end very soon, or might take a few weeks. But we don't think it's a major top.
"Again, maybe this time is the exception, and that's why we have the Cabot Tides, and why we've raised cash. There can always be exceptions to any rule, but you can't invest based on the 5% (or less) chance that it could come true."
So what lessons are hidden in this answer?
Lesson one: Your system should be a tree with a few branches.
In other words, you should never solely rely on one indicator, no matter how much you (or anyone else) believe in it. There is no indicator that's going to be 100% correct, and that means everything will mislead you at one time or another.
That's why I also use the Cabot Tides, our intermediate-term trend following indicator. In fact, the Tides is the reason Cabot Market Letter is ranked among the top five newsletters in market timing performance during the last six months, one year, and two year periods-the only newsletter that can make that claim.
Thus, in case the Two-Second Indicator is mistaken this time around, I don't put all my eggs in that basket.
Lesson two: Go with evidence, not logic. I know that sounds weird, so I'll explain.
In real life, logic is the key to solving most problems. It's amazing what a little common sense can do.
However, in the stock market, logic often does not work. Why? Because the market, in its devious way, acts in a manner that's completely the opposite of logic! Strong stocks tend to get stronger, weak stocks tend to get weaker, and you're better off quickly taking losses while holding your winners. All of these go against human intuition.
Similarly, the subscribers' question made perfect, logical sense-since most stocks have rallied so much since March, they're naturally miles away from their 52-week lows. So this time around, the readings might not mean as much (i.e., they might be artificially low). I can't really disagree with what he said.
Yet, as I explained in my response, the historical evidence (which covers several prior recoveries from steep bear markets) tells me that, whenever the number of new lows is fewer than 40, the market is not in danger of a serious, prolonged correction.
In fact, the subscribers' worry (that new lows are low because the market has rallied so much in recent months) is probably the exact reason why the indicator works! Think about it-bull markets do not up and die right away, they take time to gradually lose momentum. So if the market is coming off a stupendous upmove, the odds are low that things are going to fall apart.
But moving beyond the specifics of the Two-Second Indicator, the main point I want to make is one that I've written about frequently, both in these Cabot Wealth Advisories and in Cabot Market Letter and Cabot Top Ten Report: You should stick with the EVIDENCE the market has presented.
Really, anyone with a brain can come up with a logical reason why the market or a stock should go up or down. But it's only by having a system that's based on how the market actually works that you can gain an edge.
In this case, that means going with the historical evidence of the Two-Second Indicator's readings as opposed to second-guessing that evidence because of a personal opinion ... even if it is logical.
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As it turns out, the Two-Second Indicator has been vindicated, at least for now, as the sharp retreat in the market was reversed during the past few days. All the major indexes are back above their 50-day moving averages, and thus, the Cabot Tides have rejoined the Two-Second Indicator in bullish territory.
With that said, I am not a raging bull right this second. Far fewer stocks are looking good today compared to just a couple of weeks ago-a minor divergence that, while not totally unexpected (leadership narrows as bull markets progress), does tell you that buying power is slowly drying up.
Plus, I'm seeing a ton of sloppy charts-stocks that fell hard one week, rallied sharply the next, with every day showing the stock up or down a few points. Usually it's better to see stocks tighten up, which tells you big investors are in control, accumulating shares in a small price zone.
Still, I am a trend follower, so you're not going to catch me arguing with the market ... but I'll likely be more discerning with my buys than I was a few months ago, when nearly everything was heading higher.
Thus, in today's environment, I'm looking for companies with great prospects, and with stocks that are not only strong but also liquid (they trade plenty of volume every day) and have great institutional sponsorship.
One name that's attractive is Cree Inc. (CREE). The company is technically listed as a semiconductor company, however, its claim to fame has little to do with the chip sector and its notorious booms and busts. Instead, Cree is really something of an alternative energy story-it's the leader in the production of light emitting diodes (LEDs), which are far more energy efficient than both standard bulbs and compact fluorescent lights (CFLs).
Here's what I wrote about Cree two weeks ago in Cabot Top Ten Report:
"Cree Inc. is a leader in the production of light emitting diodes (LEDs), which are the next wave in energy efficient lighting. They consume as little as 10% of the electricity that incandescent bulbs use, generate low heat, last far longer (estimates of 20 to 40 times as long) and, unlike newer compact fluorescent light bulbs, contain no mercury and require no special handling. LEDs have been popular for years in laptops and cell phones, but as the demand for electricity rises and the efficiency of LEDs soars, their applications are expanding, especially for outdoor lighting; for instance, Cree is supplying Anchorage, Alaska, with 16,000 LEDs. With 80% of the firm's revenues coming from outside the U.S., there's a good chance countries like China, which already makes up a big chunk of business, could replace millions of bulbs in the years ahead."
I like that revenue growth is starting to accelerate (up 5%, 9% and 20% the past three quarters) while earnings are booming (up 38% and 100% the past two quarters, with a 45% gain expected in the fourth quarter). And I love the fact that the story is simple and compelling-cost savings for lights makes sense, and demand for its LEDs should soar in the years ahead.
The stock popped on its earnings report on October 21, and has been bobbing and weaving with the market ever since. Right now, I think it's a bit extended to the upside, as the 50-day moving average is down around 40. But I think it's worth a shot at buying on any controlled pullback of two or three points.
Until next time,
For Cabot Wealth Advisory
Editor's Note: More of Michael Cintolo's expert advice can be found in Cabot Market Letter, our flagship publication, which has been steering growth investors to big profits for 39 years. Mike combines Cabot's proven market timing and growth stock picking strategies to find the stock market's biggest winners for his subscribers. In fact, Cabot Market Letter was recently named one of Timer Digest's Top 10 Long Term Timers for two years. Don't miss out on the leaders of the bull market. There's never been a better time to invest.