Five Steps of a Market Bottom: Where are We?
In my January 28 Cabot Wealth Advisory, I wrote about the five key characteristics to look for as the market builds a bottom. The market has deteriorated further since then, so I thought you’d benefit from brief updates in my upcoming Wealth Advisories (starting today) so you can see how the process is playing out until the bulls re-take control of the market.
Unfortunately, the overall situation today isn’t much different than two weeks ago:
1. Extremely Negative Breadth and Sentiment Measures
Breadth and sentiment measures remain very negative, and in fact, some breadth measures have hit even more extreme levels (84% of all stocks below their 200-day lines after Monday’s wipeout). So it’s safe to say there’s enough selling for the market to turn around.
2. A Bottom-Building Process
We might be starting to see this, with the major indexes this week retesting their lows from January 20. But after so much damage, we’re likely going to need to see more than a three-week bottoming process. It takes time to get all the weak hands out.
3. Positive Divergences as the Bottom Is Built
We are seeing some early positive signs here—on Monday, when the indexes dipped back toward their January 20 lows, we saw far fewer individual stocks hit new lows (about 450 new lows on the NYSE on Monday, versus 1,395 on January 20) … a sign the broad market is holding up better than the indexes. However, I consider this a minor signal—a nice first step, no doubt, but not something that has me itching to buy.
4. The Trends Turn Up, and
5. Growth Stocks Powerfully Breaking out of Trading Ranges
Neither of these steps is particularly close to happening. If the market rallies a few percent from here, it’s possible that we could get an intermediate-term buy signal in a week or so, but that’s a big if. Plus, growth stocks are actually looking far worse these days, with many that were trying to set up plunging in recent days.
Thus, overall, I’m still in a defensive stance, though it’s possible the market could have started a bottom-building process.
How to Avoid Bear Markets and Get Back In When the Bulls Return
I want to emphasize that while the past few weeks have seen some extreme moves in the market and individual stocks, it’s nothing we haven’t seen before, and thus, it’s nothing our systems can’t handle.
Back in the beginning of the 2000-2003 bear market, our market timing system had deteriorated; we really didn’t use our market timing indicators much, partly because we didn’t have to after many years of straight-up market action. But by mid-2001, we had gotten crushed and realized the gig was up.
So Cabot founder Carlton Lutts and I developed what’s known as our Cabot Tides, which is now our intermediate-term trend following measure. A couple of years later, I re-jiggered ourCabot Trend Lines, which is our longer-term trend indicator. Together, these two indicators literally guarantee that we’ll never stay heavily invested during a major downmove, nor will we stay on the sideline during a prolonged upmove. That puts us well ahead of the vast majority of investors.
After a few years of choppy-but-rising market action, we entered a new bear market. I was put in charge of Cabot Growth Investor at the start of 2007, so when the market topped out that October, our system was put to the test. Thankfully, it passed with flying colors.
During the entire bear market, I just followed the action of our Tides and Trend Lines, along with the action of leading growth stocks. We did have a couple of intermediate-term buy signals (we actually caught a winner or two during the spring of 2008), but the overall result was that we averaged right around 50% in cash in the Cabot Growth Investor's Model Portfolio for the first eight months of 2008.
However, coming out of August, we were even more defensive, and in early September, I remember selling our remaining shares of First Solar (FSLR), a stock we first recommended more than year before and had a gigantic profit in. (We had booked partial profits three times before then, but sold our remaining shares when the stock plunged through its 200-day moving average.)
That sale left us with a whopping 90% cash in the Model Portfolio; honestly, I was nervous about having that much cash, but following the system (the trends looked awful and there were literally no stocks set up properly), I had to just sit and wait. Two weeks later, Lehman went bankrupt, and the 2008 crash ensued, so we were able to help subscribers avoid nearly all of that meltdown.
I say this not to brag (OK maybe a little…) but to bring up a separate point. At no time during 2008 did I ever write, “It’s a major bear market!” or predict the Dow would fall 50% or tell subscribers the market would fall for another six months. Instead, I simply took it day by day, week by week, and stayed in step with the market.
Trust me, my jaw was dropping as much as everyone else’s when the market was plunging in the fall of 2008, but having a system to rely on took the guesswork out of it.
I do want to emphasize that while I’m writing about 2008, I do not believe we’re in for anything approaching that kind of bear market. Even if the market remains weak for the next few months, I still believe a garden-variety bear move (20% to 25%) is far more likely for a variety of reasons.
But the point is that whatever comes, history shows that our system will handle it properly.
If you’re wondering, our Cabot Tides (intermediate-term) turned bullish in late-March 2009, about three weeks after the bear market bottom, while our Cabot Trend Lines (long-term) turned bullish in late April of that year.
If you’d like to know more on our view of the current market—and ask questions, too—join analyst Paul Goodwin’s free Lunch with the Analyst webinar, "How to Spot the Stock Market Bottom—And What Stocks to Buy When it Arrives". The webinar is on Wednesday February 17 at 1pm Eastern Time. If you can’t make the webinar in person, register and we’ll send you a link to the recording.
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A Stock with Growth AND Defensive Characteristics
As for the current down phase, our Cabot Tides actually flashed a sell signal in mid-December, so we came into 2016 with 45% in cash. And as soon as leading stocks gave up the ghost to start the year, we boosted that north of 60% within one week, and are currently more than 75% in cash.
With so much on the sideline, the goal now is to look for signs of an upcoming market bottom.
More important, I’m looking for individual growth stocks that can lead the next uptrend—stocks that institutional investors will pile into as their growth stories accelerate.
Admittedly, it’s pretty early to have a lot of conviction in which names might lead the next bull move. But I generally like to favor newer names that have great current and projected growth. It also helps if that growth is foreseeable; that’s the type of stock that institutional investors will likely build good-sized positions in when the market finds its footing.
One idea I’m growing more bullish on is Five Below (FIVE), which not only has a great growth story, but also has some defensive characteristics. Here’s what I wrote about FIVE in Cabot Top Ten Trader in mid-January:
“There’s no question that, while the crash in energy prices has many negative effects, it is putting more money in the average person’s pocket. But studies are showing any increased consumer spending has been focused on lower-priced outlets, which is boosting the outlook for Five Below. The company is a newcomer to the dollar store business, offering a variety of goods (fitness apparel, toys and games, technology accessories, beauty products, storage products, sports gear, party supplies and even candy—the focus is on teen and pre-teen customers) from $1 to $5 each. It’s a simple story to understand, and fundamentally, management has done a decent job of executing over the years—sales have generally risen in the mid-20% range, with earnings growing in the 30% range. Growth is likely to slow a bit going forward (mostly because Five Below is bigger), but business is definitely good today; management announced that sales for the last nine weeks of the year rose 24%, including a 4% jump in same-store sales. Moreover, management believes there’s huge potential going forward—it had 434 stores at the end of October, but sees room for 2,000 stores in the long term. During the next few years, Five Below is looking for 20% annual sales and earnings growth through 2020, which seems feasible even if the economy hits a rough spot. This is a good growth story.”
The stock itself bottomed in early December and has actually been trending higher since then, which is very impressive given the market environment. It took a hit in recent days, but found support near its 50-day line. I think FIVE is a great stock for your watch list, though if you want to take a shot, buying a little around here with a tight stop could work if the market finds its footing.
For more updates on Five Below or additional stocks which you can put on your watch list, consider taking a risk-free trial subscription to Cabot Top Ten Trader.
And you can follow me on Twitter @MikeCintolo to get my thoughts and updates on the market.
Chief Analyst, Cabot Growth Investor and Cabot Top Ten Trader