Pennies and Bulldozers

 
Pennies and Bulldozers

Day by Day

A Premium for Steady Growth

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One of the most difficult things for any investor to do is ... nothing. To sit on his hands. To do nothing but observe. To wait patiently for solid set-ups to come around.

Of course, doing nothing can be relatively easy when the market is crashing like it did in early August. At times like that, most investors are pleased with themselves for avoiding the damage!

But after etching out a brief bottoming pattern, the market has begun to rally ... and that can make those sitting on the sidelines squirm.

So what does the average investor do? He buys. Not because he has a buy signal from a dependable market-timing indicator, or because he sees a plethora of set-ups among individual stocks. No, he buys because he feels the pressure of underperforming--the market is up a few percent, many stocks have bounced 10% or 15%, and he is not benefiting from the move.

Now, if this person is a very short-term trader, he may be successful.

But if he's like us--concentrating on the intermediate- to longer-term end of the spectrum--he'll probably lose money as the market's major downtrend eventually reasserts itself, leaving the late buyer with losses. At best, even if the investor proves nimble, the money made by these trades is usually small, at least compared with the risk, frustration and volatility involved.

This is what I call picking up pennies in front of a bulldozer--yes, there's a very good chance that you can run out there, grab the change and get out of the way before the bulldozer runs you over. But if you don't, it's very bad news! In other words, you may make a few bucks, but the risk isn't worth it.

However, that's the situation most investors work themselves into--refusing to let any type of bounce or rally go by without participating in it ... even if the potential rewards are small.

Don't get me wrong--I am human and subject to the same emotions as everyone else. And yes, sometimes I'll probe here or there during a nascent rally. But I usually do it for a reason, i.e., some secondary indicator I have faith in, or pattern that I've seen before, tells me the odds are at least decent that there's some money to be made. Otherwise, I try to lie low.

My stance comes from some post-op analysis I did a few years ago. I found that, for all stocks I bought when our Cabot Tides (our intermediate-term trend following indicator) was negative, my total return was about ... zero.  

Yes, sometimes I got in the right stock earlier than I otherwise would, but the extra money made in those trades was offset by the times I bought into false rallies (the Tides never turned positive, as the market turned south), and by the times I purchased a stock that faltered (it turned out not to be a real leader, even though the market was turning up). In return for zero return, I got a lot of stress, heartache and worry. Not worth it!

(The one exception to this "rule" of not buying before the Tides turns positive is if you see a big, liquid leading stock that leaps out of a multi-week base on huge volume; in this case, you can jump on the stock, as it works out well a good percentage of the time. This is something to keep in mind, especially if sound launching pads continue to form in the weeks ahead.)

Even outside the liquid leaders, you can still do some buying; investing isn't an all-or-none approach. But history has taught me that if I'm going to play these early-stage rallies, I should play them very small (keep position sizes to one-third to one-half of what I'd normally buy) and watch them closely (tight stops, partial profits on the way up, etc.).  

Put another way: Go along with the short-term move if you want; there's absolutely nothing wrong with doing so. But remain generally skeptical until you develop meaningful profits and the market decisively turns the corner. Your main focus should be on the larger "easier" profits that come during a clear uptrend in leading stocks, rather than the small, difficult profits that come during choppy markets with lots of uncertainty.

I want to take a minute to write about the month of September, which, of course, we've just begun. In case you don't know, historically, September has been the worst month of the year for the market; since 1950, it's averaged a loss of about 0.7% every year. I've heard all kinds of theories why this is the case, from mutual fund selling (many funds have fiscal years ending Halloween) to a hangover from the summer.

In any event, I don't really care why, and I don't really care about the historical returns. In my opinion, too many investors put too much emphasis on the calendar; at best, seasonality is a modest push for or against the market. But it's not like institutional investors are going to buy or sell more because it's November instead of September. If they want in or out, they're going to do it, regardless of the calendar.

The reason I write about this now is because of what I heard last September--after a four-and-a-half month correction, stocks were apparently set to fall off a cliff in September, partly because of seasonal factors. Instead, stocks took off like a rocket and advanced 9% during the month, kicking off a huge six-month rally!

I am certainly not suggesting that is going to happen again this year, but the point is that every investor is trying to foresee what's to come--investing is an inherently uncertain game, and the human mind deals with that by trying to inject surety.

Instead, it's best to learn to live with the uncertainty, and just take it day by day, week by week, and go with the evidence the market is giving you. It's something to keep in mind as pundits are sure to throw many more forecasts at you in the weeks ahead.

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If you're looking for a stock to buy at this time (small positions only!), you're going to have to adjust to the market environment. Specifically, dependable, steady growth is at a premium, as market participants are worried over the threat of a recession. Thus, the triple-digit growers that I love are worth watching ... but for now, they remain in base-building mode as the market attempts to repair itself after the train wreck of a month ago.

Because of this, some of the best charts are found not in traditional defensive issues (Coca-Cola and such, which I have no interest in) but in names with some expansion potential ... but not a lot of economic risk.  

Dollar Tree (DLTR)
is a perfect example--it's not sexy, but that's the point!  Here's what we wrote about the stock in Cabot Top Ten Trader back on August 22:

"When the market gets rough, big investors look for well-traded stocks with a defensive flavor, but also prefer those that have at least some hint of growth to them. Dollar Tree fills the bill perfectly, as its low-priced merchandise is attractive given the stagnant job market, and should become more so as the U.S. economy slows down or even slides into recession in the months to come. Plus, management has been deft at expanding the store count (up to 4,242 stores at the end of July) and total square footage (up 8.9% in the second quarter) to take advantage of the increased traffic. All told, sales have been cranking higher in the 12% to 15% range for many quarters, while earnings have generally grown faster thanks to higher margins. That trend continued in the latest quarter, with sales up 12%, same-store sales up a strong 4.7% and earnings up 26%, all slightly better than expectations. Even better, growth picked up as the quarter went on, suggesting the slowing economy could actually be helping business. Dollar Tree won't make you rich, but it looks like a solid port in the storm right here."

Since then, the stock has surged to new highs on very good volume as big investors look for safety and growth. Buying strength hasn't been the best idea in this environment, and happily, DLTR has retreated a few points this week.  

If you're game, a nibble around 70 could work, with a stop in the mid-60s. Again, though, keep positions small if you decide to play in this environment.

All the best,

Michael Cintolo
Editor of Cabot Market Letter

Editor's Note: Some investors can make good money in bull markets, and some are good at avoiding damage in bear markets. But to have great returns, you need to do both ... like Mike Cintolo (VP of Investments for Cabot) has done as editor of the Cabot Market Letter's Model Portfolio. Since he took over at the start of 2007, Mike has outperformed the S&P 500 by 13.6% annually thanks to top-notch stock picking and market timing. To benefit from Mike's advice during these challenging times--and to know when and what to jump on when the bulls re-take control--be sure to give Cabot Market Letter a try by clicking HERE.



Michael Cintolo can be found on Google Plus.

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