A Word About Whipsaws

 
It's What You do with the Information that Counts

Judge a Stock on its Own Merits

A New Technology Leader?

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I wanted to write briefly about some events that transpired in Cabot Market Letter during the past couple of weeks, and some feedback I got about them.

As you know, the market put on a decent, but not great, show of strength a couple of weeks ago, and it was enough to flip our intermediate-term indicator (which simply follows the market's trends) back to bullish. (It had been negative since August 2.)  In response to that, I advised subscribers to take a couple of small--emphasis on small--steps back into the market; we went from a huge 73% cash position to a still-large 56% cash hoard.

As we now know, that buy signal lasted about as long as a Red Sox starting pitcher this month (read: not long!), as the market took a few clouts to the head late last week. I quickly backed off in the Cabot Market Letter's Model Portfolio; our cash position is now around 67%.

In response to the whipsaw, oh boy, did I get some angry emails. "What kind of market timing system is this?!?" "I lost a ton of money because of you!" And "You clearly have no idea what you're doing!"  

This whole process brought a few thoughts to my mind, which I want to share here.

Would I qualify this as a successful buy signal? Of course not; no one likes to get whipsawed. But that is simply going to happen from time to time with a trend-following system ... which brings me to my first point. And that is, you have to understand the positives and negatives of whatever system you're using.

For instance, if you're a growth stock investor who cuts losses short, guess what--you're going to occasionally have to cut a loss just two or three days after buying. That can be tough to do and a blow to the ego. That said, if you're a value investor, you'll never suffer through that ... but you might have to hold a stock for months before it makes any real progress for you, which a growth stock investor would never do.  Both systems can work, but each has its own plusses and minuses.

Back to trend following, I love it because it guarantees I'll never miss out on a major upmove, and it also guarantees that I'll never stay heavily invested during a major bear phase. To me, those two plusses far, far outweigh the occasional whipsaw. Thus, when a whipsaw occurs, I don't freak out or lose faith in the system; I know it's part of the game, and eventually, we're going to catch hold of a very profitable uptrend.

Another reason that whipsaws don't bother me too much is because I don't suffer too greatly when one occurs ... which leads me to my second point. As I wrote above, after the buy signal, we slowly started to come off the sideline; we still held more than half our portfolio in cash. But I'm sure that if someone went full bore on the buy signal, they would have felt some serious heat.

In other words, it's not the signal itself that matters as much as what you do with it. With a trend following system, knowing there will be whipsaws, we usually go slow soon after a signal (buy or sell); that way, we don't have to totally reverse ourselves if the signal falters.  

Now, none of this is to say that the whipsaw is a good thing that doesn't cause some angst, or that, using the example above, it doesn't wear on an investor who holds a value stock as just sits, or even falls for a while, after your purchase. But understanding the ins and outs of your system, and of the potential risk and rewards of your action, helps keep things in perspective.

And in the market, perspective is very valuable.

Switching gears, I wanted to quickly touch upon a topic that is likely to come up in the weeks ahead. That is, once we get a new, sustained uptrend, what stocks do you buy?

Unfortunately, many investors go right back to the trough of the last uptrend. They'll talk about Baidu (BIDU), Acme Packet (APKT), Riverbed Technology (RVBD) and Salesforce.com (CRM). After all, all are still good companies, all are still posting solid growth, and the underlying drivers of their growth are still in effect. So why wouldn't they be good buys?

The funny thing is that, when coming out of a "normal" bull market correction--three-to-six weeks, maybe 8% to 12% declines in the indexes--such thinking often works. The leaders of the bull market are leaders for a reason, and they tend to lead through at least one correction (or, in the case of a mega-leader like Baidu, for the entire bull market cycle).

However, I believe that, no matter what you want to call the current downturn (bear phase, sharp correction, etc.), it's been long enough and deep enough that many of those "old" names won't come back. But don't take my word for it--take the market's word.  

That is really the point of this whole discussion. If the stock you're considering is sitting 35% or 40% off its prior peak, it might rally for a bit when the market does. But it's not a leader anymore; a drop that severe, especially coming over many months, clearly tells you that perception has changed. Dead cat bounces can happen, but new, sustained upmoves are far less likely.

All of this is why I often harp on keeping an eye on those stocks that are resisting the market's downward pull. By definition, these are the names that big investors are reluctant to sell ... and hence, have a great shot of delivering profits during the next bull run. And, yes, some of them might be those "old" names--Apple (AAPL), Green Mountain Coffee Roasters (GMCR) and some others are still hanging in there nicely.

But don't fall into the trap that, because a stock was good during 2010 or earlier this year, that it's necessarily going to be good when the market gets going again. More likely is that those obvious, overplayed, over-owned names will lag as some fresher merchandise leads the next upmove.

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One of those pieces of fresh merchandise is Universal Display (PANL), a small firm with a (very) long history of losses and little institutional support. But that's now changing, and it's all because of its leading position in OLEDs (organic light emitting diodes), which are looking more and more like they'll be adopted en masse for smart phones, TVs, tablet computers and more.

So how will this benefit Universal Display?  It owns more than 1,000 patents, and it's aiming to be a licensing company; in fact, it's recently inked deals with Panasonic and Samsung, which sent the stock into orbit. Valuation is truly at nosebleed levels--the firm has no earnings and just $39 million in revenue, but the market cap is $2.3 billion!

That said, high valuations don't scare me, partially because I focus on the future. Revenues have been growing nicely, and if Universal's licensing business can lift next year and in 2013, profit margins will go through the roof and earnings will explode. Currently, a handful of analysts that have estimates see revenues up 63% this year, but rising another 104% next year. And earnings could go from about breakeven this year to 86 cents per share in 2012.

I won't pretend to know all the ins of outs of these estimates, but my experience is that when a new technology gets adopted by the market, it's usually done so far faster than most expect, causing the bottom line of the firms who benefit to grow at lightening fast rates. I'm not predicting that will definitely happen with Universal Display, but I'm open to the possibility.

I'll look to the stock for clues. Shares did have a big run late last year and earlier this year, but then suffered a harrowing drop of more than 50%. But that's when the action started--a new licensing deal caused the stock to jump a jaw-dropping 85% during the last week of August on weekly volume that was both quadruple the average rate, and more than twice as large as any total in the stock's history.

And since then, PANL has held those gains, actually rallying all the way back to its old peak of 60 before backing off with the market's latest weakness. I would love to see this stock meander in the 45 to 55 range (it's a very volatile name) for a few more weeks, then blastoff with the market.

Right now, a nibble in the upper 40s with a stop around 42 is OK if you're aggressive, but I would rather wait for a proper, tighter set-up. Watch for it.

All the best,

Mike 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. Since he took over at the start of 2007, Cabot Market Letter has outperformed the S&P 500 by 13.8% 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 today

Michael Cintolo can be found on Google Plus.

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