Unexpected Events Occur Frequently

 
Normal vs. Abnormal in the Stock Market

Market Bottoms are a Process, Not an Event

Follow the Volume

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The market's plunge during late July and early August has left more than a few investors stunned.  After all, the headlines certainly dramatize the drop and emphasize how unusual it was.  And, indeed, it was a very sharp decline--the Dow fell nearly 17% in just 13 trading days!

That said, one truism about the market is that the so-called unexpected actually occurs somewhat frequently.  Said another way, unusually big moves--over a couple of weeks or an entire year--occur far more often than the media lead you to believe.

For example, take the 10% return figure cited so often by investment pundits--the market rises, on average, about 10% per year over the very long-term.  Thus, you would think that, for the most part, returns far above or below that 10% level would be rare.  But that would be completely wrong!

As it turns out, a full two-thirds of all years showed returns that were at least 10% above or below that 10% average--that is, two-thirds of all years returned at least 20%, or less than 0%!  Taking it a step further, a huge one-third of all years were a gigantic 20% beyond the average (above 30%, or below -10%).

Of course, I'm talking about full-year returns here, but even when you look at shorter periods, the conclusion is the same.  

I did a quick study of all the two-week market returns since the start of 1980; on average, the market rose a morsel less than 0.4% during any given two-week stretch.   

Again, you would figure that, given the 0.4% average, it would be highly unusual to see, say, a 5% move up or down in a two-week span.  But such a large, outsized move actually occurs about 10% of the time--put another way, you see a 5% rise or fall within a two-week span a few times each year!  And this is for the big-cap S&P 500, not the more volatile growth stocks I tend to focus on.

The moral of the story is that, in the market, yes, you're going to see a relatively smooth average return over many years and decades.  But because humans are involved, big moves, even in a relatively short period of time, occur far more frequently than most people realize.

That's why the general advice of cutting losses short (which prevents you from getting burned during outsized market declines) and letting at least a part of your winners run (helping you benefit from the outsized rallies from time to time) has stood the test of time--in the market, to make it big, you have to avoid big downturns, and take advantage of the dramatic rallies when they occur.

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Back to the current market environment, I want to expand upon something I touched on in a special video I did last week during the market's mini-crash.  In that video (click here to watch it), I presented a couple of examples of past market downturns and looked at how they bottomed out.  No two markets play out exactly alike, but history does rhyme to some extent, and here are five things to look for in the weeks to come.

First, it's highly likely that the recent bounce that persisted through Monday will fail.  That doesn't mean it will lead to another collapse, but the odds of the market running straight up from here are very low.  In fact, if it somehow made it most of the way back toward its high right away, it would probably be etching an even larger top.

Second, expect choppy action for many weeks.  Following sharp selloffs like we just saw, bottoms are generally a process, not an event--it takes TIME to wear out all the shareholders that, to this point, have been too stunned to let go of many of their shares.  So don't anticipate straight-up or straight-down action; more likely are some big gaps, big reversals, reversals of those reversals and so on.

Third, somewhere in the vicinity of four to 10 weeks after the initial low, look for a re-test of those lows; that would put us in the vicinity of early September through mid-October.  Now, that re-test doesn't have to find the indexes dropping down precisely to the prior lows--sometimes it's higher, sometimes it's lower.  And sometimes you see multiple re-tests of the low!

Fourth, during that re-test, you want to see some positive divergences--the number of stocks hitting new 52-week lows should dry up compared to the first low (come in less than 1,292), and, importantly, you should see many growth stocks (not just defensive-type issues like utilities or food stocks) well above their early-August lows.  That tells you that, while the headline Dow or Nasdaq may look sick, the action underneath the market's hood is more encouraging.

Then, fifth, you need to see the market and individual stocks take off to the upside.  This last part might seem obvious, but you'd be surprised how many investors try to jump the gun!

This is how a bottom occurs--not with one panic day, but over many weeks as big investors re-position their portfolios away from what's already been played and toward newer names.  Bottoms are a process, not an event.

What happens if one of these steps doesn't occur?  What if the "re-test" turns into a full-fledged rout?  Well, then, you wait patiently for a bottom to be put in!  There is no set timetable for a low--yes, the re-tests can occur in the four-to-10 week timeframe mentioned above, but sometimes it takes much longer, especially if it's a deep bear market.  The key is to wait for a bottom to be built, and then for upside confirmation, before taking big swings at growth stocks.

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Speaking of growth stocks, I still think it's a bit too early to really dig in and find those names that have either resisted the downturn, or got hit but snapped back with power.  The reason is that nearly every growth stock has some serious damage on its chart, which will take time to repair.  Thus, while it's nice to see some things snap back, even the most resilient names likely need a few weeks to consolidate.

However, one thing I do like to look for is unique, extraordinary volume clues to tell me that, at the very least, some big institutions are swallowing up some shares of a favored growth name.

Two that I noticed last week with such volume clues were MAKO Surgical (MAKO) and Rosetta Resources (ROSE). (I recently had to sell the latter because of a loss.)

MAKO Surgical is a classic growth stock, though it's very small (just $58 million in revenue during the past year!).  But it's developed a robotic surgical system used for knee and (by the end of the year) hip resurfacing and replacement.  The firm isn't profitable, but it's been growing revenues at an 80% clip.

The company reported great earnings last Monday evening (August 8) and that resulted in the stock leaping more than 30% on its heaviest volume ever; for the week, shares vaulted 32% on the biggest weekly volume total ever.  The chart is very wide-and-loose, so I can't say it's a screaming buy, but it's certainly one to watch.

Rosetta Resources is a stock I was forced out of recently because we bought it too high, had a loss and the market was weakening.  But, interestingly, the stock found support around its 200-day moving average last week on a weekly volume total of 15.8 million shares--nearly twice as large as any week in the stock's history!

The story here revolves around the Eagle Ford Shale, where Rosetta is rapidly expanding production.  Sales and earnings are just starting to lift off, and earnings estimates are strong, though of course, they can move around with the price of oil and natural gas.

Again, ROSE doesn't look like a great buy here--its chart needs some time to calm down and round out.  But given the volume clue, it's worth watching to see how its base-building effort progresses.

All the best,

Mike Cintolo
Editor of Cabot Market Letter

Editor's Note: Mike Cintolo is VP of Investments for Cabot, as well as editor of Cabot Market Letter, a Model Portfolio-based newsletter of the best leading growth stocks in the market.  Mike took over the Market Letter at the start of 2007, and since then he's beaten the S&P 500 by 14.5% annually thanks to top-notch stock picking and market timing.   If you want to own the top leaders in every market cycle, be sure to give Cabot Market Letter a try by clicking HERE.

Michael Cintolo can be found on Google Plus.

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