Surviving the Meat Grinder
Party like it’s 1999
Today I wanted to write a bit about stock charts, but instead of getting into the commonly referred to (but usually useless) patterns like “head and shoulders,” “triangles” and the like, I wanted to talk about something chart-wise that has helped me to both pinpoint some great buying opportunities … as well as avoid riskier situations.
What is this mystery chart pattern? Well, it’s not really a pattern at all. It’s just a manner of trading that is easy to see when you examine a chart. I’m talking about “wide and loose” versus “tight and right.” I’m going to explain each below, what they mean, and what they imply for your trading.
Wide and loose trading is just that—a stock that is up 7% one week, down 4% the next, up 4% the week after, and then down 5%. In other words, the stock is whipping up and down day after day, week after week, as the bulls and bears battle it out. This situation, especially in a stock that’s had a big run-up in recent months, is a bad sign. (Marvel Technology (MRVL), shown above, is an example of this.)
Why? Because the stock’s wild ups and downs are telling you that the public’s eye hasn’t come off the stock … something that is needed for the stock to build a sound consolidation. If everyone is still following and involved in a stock, that means not enough shares have been moved from weak hands to strong hands, so the consolidation phase, at the very least, must go on longer—or it may fail altogether.
Yes, it’s true that some consolidations are going to be a bit wild depending on the market’s action. For instance, you saw quite a few whippy charts at the major market bottom last March, mainly because the market itself was so volatile. Even so, you usually saw the best stocks show at least some tightness, as most investors gave up, and professionals moved in.
Tightness is an indication that big-money investors are “in control” of the stock. They are buying shares within a certain price range, and thus, the stock tends to go straight sideways for a few days or even weeks. It also tells you that all the weak hands are out; if they weren’t, the swings would be more intense, as described above. (Rovi Corp. (ROVI), shown above, is an example of this.)
So why am I writing about this today? Simply because recently we’ve seen many of these wider-and-looser patterns form. Yes, some of that is because of the market itself, which has been spiking up and falling down for the past few months. But after monster advances during the past year-plus, many of the best-known growth stocks in the market have been sloppily chopping around … a sign most that investors are familiar with their stories and are following the companies on a week-to-week basis.
These patterns are failure prone—when a stock breaks out from this pattern, it usually makes a little progress … but then quickly gets smacked back. What’s obvious in the market rarely works! Of course, not every loose pattern will fail (a strong gap up on earnings, for instance, can always change the playing field), but the odds are against it leading to a major, sustained upmove.
The good news is that these wide-and-loose patterns can eventually tighten up. Usually, after a few failed breakouts, most investors throw in the towel and move on. Then, assuming business prospects are still compelling, the stock often tightens up, breaks out and begins a new advance.
The moral of this part of the story: It’s not just whether a stock is generally trending up or down that’s important. How the stock is acting is also important—if it’s a popular name and is swinging around wildly, don’t be in a hurry to buy. You’ll usually be better off waiting for a tighter pattern before putting any hard-earned money to work.
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Speaking of being better off waiting, I also wanted to touch on something that hurts many investors, especially in this type of environment. That something is the ability to do … nothing. That’s right!
It’s hard for most investors to do nothing because, let’s face it, in life, success is usually defined as the ability to get things done. If you’re a salesperson, you go out and sell stuff. If you’re a teacher, you teach people. It’s not often you find a profession where the right move is to do nothing.
Moreover, just think of the ways people involved in the stock market are described—investors (you invest) and traders (you trade). Nobody describes themselves as “somebody who occasionally buys stock and sometimes does not.” Doesn’t quite have that catchy ring, does it?
Yet the lesson I’ve learned many times (too many times, unfortunately) is that the more you trade, the worse you’re likely to do. I don’t mean, necessarily, that a swing trader will make less than a long-term investor. What I mean is that, if you normally make 10 trades in a month, and then kick that up to 25, your results are likely to decline markedly.
Really, so much of garnering above-average investing results comes from not losing money. Part of that, to be sure, is to cut all losses short. But part of it involves avoiding the “churn periods”—those times when you seem to be buying and selling, buying and selling, buying and selling, but not making any real progress, often taking a bunch of small losses each time. The end result: Poor performance and larger drawdowns.
Usually, this churn comes about because an investor fears missing an upmove; he or she sees a good-looking stock with an attractive story, and thus buys the stock even though its chart or the market isn’t quite right. Or, in the current environment, that investor might get sucked into buying a bunch of stocks every time the market stages a solid up day … only to be forced to sell a week or two later when the downtrend reasserts itself.
Here is a vital point: Having studied my monthly results for my own trading, I can tell you that it’s usually just a couple of months each year that “make” my year. In other words, in a decent year, there are usually two or maybe three months that I really make good money, while the rest are either right around breakeven, or have small losses.
Thus, while most people think that doing nothing is an investment sin, I actually think the opposite: If I could eliminate or cut back on my trading during those “bad” months, I could boost my results in a big way! This is actually one of the hardest lessons for me to implement, partly because it’s my job to sit in front of my computer.
Nevertheless, I’ve been working hard to trade less—forcing myself to wait for the proverbial fastball down the middle of the plate—which has helped me avoid more serious losses during challenging market environments like we’ve been in since early May. I think it’s a good lesson for everyone; more trading is not always better … in fact, it’s usually worse!
As always, during this difficult market period I am working hard at building my Watch List and keeping it up to date. That last part—keeping it up to date—is difficult right now because earnings season is again upon us. And that means a daily dose of big gaps up and down among growth stocks, depending on how investors react to and interpret the news.
Thus, if you are going to be doing a little nibbling on stocks here and there (and I don’t think there’s much wrong with that, assuming you have plenty of cash on the sideline), you have two choices. First, you wait for a company to report earnings, and then look to buy afterwards if the chart and story are still intact following the report.
Or you can look for strong, enticing growth stocks that aren’t set to report results for another few weeks, to give the new position time to develop a profit cushion for you before the quarterly report is out.
One stock that fills that bill is Finisar (FNSR), which has shown up in Cabot Top Ten Weekly a few times this year, including a couple of times recently. It’s a story right out of 1999, as the company is the world’s largest supplier of optical gear for telecom equipment. And that means the company is riding the boom in bandwidth demand, which stems from the flood of data and video now traveling over telecom networks thanks to myriad smartphones and other wireless devices.
Verizon is pouring billions of dollars into its 4G network, and other providers like AT&T aren’t far behind. The new iPhone 4 (despite its well-publicized issues), the iPad and the popularity of Android phones should accelerate the need for faster networks, and Finisar’s equipment is a big part of that. I could get into more details, but honestly, that’s the ruling reason—more bandwidth means more demand for Finisar’s equipment.
As for business, it slipped a bit during the recession, but not tremendously (sales growth was down 11%, up 12% and down 1% during the final three quarters of 2009). And now it’s really ramping up—sales rose 33% and 76% the past two quarters, and estimates call for 56% and 41% the next two quarters. Earnings, by the way, have ramped up from three cents to 11 cents to 17 cents to 22 cents per share during the past four quarters.
The stock itself notched an impressive 10 weeks up in a row during February, March and early April before settling into its current choppy consolidation. The good news is that shares haven’t budged much despite the market’s correction—FNSR has actually hit a series of higher lows since early May, and is now within range of breaking out above 16.6. A strong-volume move above that level would be bullish.
And, as mentioned above, earnings aren’t out until September (its quarter doesn’t end until July 31), so buying a little here or on a decisive breakout has a good shot at working out. Just remember to keep positions small until the market enters a new, definitive uptrend!
For more details on Finisar and other top stocks featured in Cabot Top Ten Weekly, click here.
All the best,
For Cabot Wealth Advisory