Keep Your Powder Dry

Tuesday’s market action should have reinforced your resolve to stay out of this market until we get some confirmation that it will go higher. Because three out of four growth stocks follow the market’s direction, the odds are against you if you dare wade into a market in a correction.

The market showed a little promise recently, but it has been rejected at the 50 day moving average, a key trend line. Looks like big investors aren’t big buyers right now. Hold tight and let the market tell you what it’s going to do.

MELI Voted Off the Island?

I recently put MELI on my watch list as a stock worth keeping an eye on because of its solid fundamentals and potentially sound consolidation pattern. However, Tuesday it took a huge hit in big volume, indicating serious selling.
While it found support at its 200 day moving average and finished the day in the upper half of its range, the action should give one pause. It’s possible it could recover or form a double bottom (but you wouldn’t want it to go much further below its recent bottom), but it gets pushed off my hot list for now.

If you didn’t have a chart to look at, you could easily conclude that it’s a sound company given its results. 136% EPS growth and 47% sales growth would make any company happy, but these results missed expectations. That’s all it takes.

Additionally, MELI has felt the “Hugo Chavez” effect. Because the socialist dictator-in-the-making devalued Venezuela’s currency, it cost MELI $7 million in revenue. Ah, the joys of Latin American stocks. How many other stocks have exposure to Venezuela? Makes one wonder.

For now, MELI has been voted off the island.

Essential Reading List - Start Right Now

Read, read and read some more. This is a common trait of successful stock investors. Nicolas Darvas, who himself wrote a book How I Made $2Million in the Stock Market (and that’s two million 1959 dollars!) read over 200 books on investing.

Perhaps you can’t find the time for 200 books; that’s fine, Darvas was an overachiever. You can gain a perfectly firm foundation in stock investing with a handful of good books. All the others you read will help to keep your mind sharp and tighten your skills.

I get asked all the time what books to read, and I tell people, and have even bought people these books, and they almost never read them. Guess what? You know the answer. So at least read a core group of books and you’ll be ahead of the curve and gain an edge in the market. I’ve known plenty of professional stock brokers who haven’t read many books and who haven’t educated themselves on the different approaches out there.

My essential recommended reading list (focused on growth investing) you should tackle before investing serious money is as follows:

The Dow Theory, Robert Rhea
Reminiscences of a Stock Operator, Edwin LeFevre
The Battle for Investment Survival, Gerald Loeb
How I Made $2,000,000 in the Stock Market, Nicolas Darvas
How to Make Money in Stocks, William O’Neil

While I think you should read books on different styles of investing (value investing, technical analysis, dividend plays, etc.), I prefer investing in stocks poised for tremendous growth, and this reading list favors this approach.

The Dow Theory might be the toughest to get through as it is a bit dry and somewhat dated, which makes it a little unclear. You have to excuse, or put into historic perspective, the book’s heavy emphasis on the railroads, which were a much more significant element of the American economy over 100 years ago. Nonetheless, the book serves as a nice explanation for stock market movements from the eyes of none other than Charles Dow and a long-time editor of the Wall Street Journal, William Peter Hamilton. These two wrote numerous articles explaining how the market moved and how to interpret these moves. This work put into book form the essence of Dow’s theory, which is still fundamentally applicable today.

My favorite book on the list is Reminiscences. It is a thinly veiled account of the life of the famous stock investor, Jesse Livermore. It’s a colorful read in narrative form of Livermore’s life, sure to entertain and educate.

Gerald Loeb’s work is a good one for general stock market themes and the wisdom of investing, not so much for a specific system. Perhaps the most important piece of advice in the book is cutting your losses religiously, and the keen observation that stocks which make new highs generally continue to do so, while stocks that make new lows generally continue to do so.

Darvas’ book is a lot of fun to read. It’s a blow by blow account of a man who educated himself in becoming a truly successful investor, and who did so despite traveling the world as a professional dancer in the late 50’s without the internet, cell phones, computers or even up to the minute information (he had stock quotes wired to each hotel he’d be staying at each day).

O’Neil’s book opened the world of investing to me. If you were going to only read one book, read that one (even though my favorite read is Reminiscences). O’Neil is very much like Darvas in that he educated himself and researched heavily to develop his theories. O’Neil actually studied the exact buys of the best funds in the country to discover what they were doing. He ordered their records and found some of the best funds were purchasing shares of stocks that were hitting new highs – counterintuitive to many investors. He catalogued thousands of stock charts and poured over them, discovering a timeless movement in winning stocks. Buy his most recent book and you’ll see for yourself the actual stock charts of companies from the late 1800’s to today in there. You will be amazed at how the stock patterns repeat themselves in each bull market. It speaks for itself.

I have some of these charts (and the original stock certificates) framed on the walls in my home to remind me of these winners.

PCLN: A Watch Stock, But Watch the News

I focus on one of my watch list stocks today, PCLN. It has been a rock star this year as the chart below shows (IBD's Daily Graphs is a service any serious stock investor must consider subscribing to - I wouldn't invest without it). It was a great stock before the bear market, took a dive like pretty much all the stocks out there, and then regained its old form.

The number of funds owning shares has cruised higher by 22% in six months, an encouraging sign. Weekly accumulation is clear on the chart and it sports a B- in the IBD’s accumulation/distribution rating, which is just fine.

The earnings of this company are fantastic. It’s annual earnings are projected to grow 30% this year and 20% next near, just what you want to see (I like to see at least 20% in the current year). It has shown two quarters of accelerating EPS growth with a third projected for next quarter (50%), and it shows three quarters of accelerating sales with the possibility of a fourth in a row.

Technically, the chart looks nice. It had a great uptrend before forming its current cup pattern. The current consolidation shows two net weeks of accumulation and it’s break out week, last week, shows a volume spike on the weekly chart – just what you want to see. It suggests big money is flowing into the stock. It technically broke out of a cup base Thursday and has backtracked on light volume since. Because the market is in a correction, i.e., it isn’t saying it’s ready to go higher, I didn’t pull the trigger on it. It could go on to form a high handle to the current pattern, and if it does, the buy point would be $235.90.

But what do you do when a negative news story comes out about a stock you are stalking? Tuesday’s IBD has a feature article on Priceline and Expedia possibly facing headwinds in their growth. It basically says even the CEO of Priceline openly acknowledges that comparisons will become tough as we move forward, and economic conditions may not favor such future stupendous growth as we’ve seen in the past.

Investors have become quite familiar with Priceline, so expectations are great – this means it likely needs to beat earnings estimates by a very healthy margin to not continue moving higher.

So what do you do? This is part of the art of investing. I may shine it and take my chances with less uncertain stocks that still show no signs of slowing. We’ll see.

My Current Watch List

There are a number of stocks with great fundamentals setting up in consolidations right now, a great sign. As mentioned in previous postings, not long ago it was tough finding stocks with excellent fundamentals that were going through constructive basing patterns. It is encouraging to see so many more, although no where near what it was like during the height of the previous bull market.


My current watch list includes the following stocks:

ATHR
PCLN
WDC
GMCR
CTRP
HMIN
LULU
AIXG
NTAP
GIL
MELI

This list was developed from scouring all the stocks listed on the NASDAQ, the NYSE and the AMEX. I use a stock screening software provided by the Investor’s Business Daily (IBD) Daily Graphs company. I am still developing my watch list, as I am always looking for new additions to my watch lists. The general criteria for the list above was that they were in the top 20% of all stocks in terms of EPS rating, top 20% in Relative Strength rating and composite rating (a proprietary ranking methodology of IBD’s) and that they had at least 25% EPS and sales growth in the most recent earnings report. I also set a minimum for rate of return, an important component for determining the financial health of a company.

As you may infer, this list is not based on emotional attachment to an industry group or an old favorite, it was developed based on how the stocks are currently behaving. It is based on where the money is flowing. Astute thinkers and observers of economics and business practices, many stock investors forget a basic fundamental of stock investing: supply and demand. How ironic that we all are taught this basic aspect of capitalism, and in microeconomics specifically, yet most forget to apply this to the stock market – a monument to our capitalism itself!

Money flows into and out of stocks necessarily affects the current price of a stock. Therefore, another key aspect of how I develop watch lists, and which stocks I favor on my own watch lists over others, is the number of shares outstanding and whether a stock is being accumulated or being sold off. IBD offers the Accumulation/Distribution rating, a proprietary measurement that suggests whether the big players are buying the stock or not. But you can also see accumulation and distribution by just looking at a stock’s chart. That’s why I don’t like stock chart services that do not indicate this key aspect clearly (can I get a mobile phone app that shows volume!?!).

After I’ve developed a watch list, I create research packets on each stock that includes balance sheets, analyst opinions, projections, news stories, profiles of the company and other such pertinent information.

Once I’ve decided on which stocks I like best (I usually prefer the stock that shows most earnings growth), I wait until the stock breaks out when the market is in a confirmed uptrend.

Keep an eye out, the market is showing some positive action. Don’t try to predict where it goes, simply react to it once it tells you where it goes.

ATHR Setting Up in Cup Base; Fantastic Fundamentals

With the stock market’s action suggesting it wants to go higher out of this current correction, you should have an active watch list of strong stocks once the market officially begins a new uptrend. I have found the best tool for deciding when to begin buying stocks again is the Big Picture found in the Investor’s Business Daily (IBD). Their methodology for tracking uptrends and corrections is a great way to get in and out of the market safely.

One outstanding stock setting up in a cup-shaped pattern is Atheros Communications (ATHR). It could go on to form a handle to the cup, which is the most powerful of chart patterns to buy off of. But for now, the buy point to the cup is $37.44 plus $.10 which makes the buy point $37.54. I only buy a stock once I see volume surge 50% on the day it breaks above the resistance level, which in this case is $37.54.

ATHR is showing outstanding fundamentals. It has 3 quarters in a row of accelerating earnings per share (EPS) and sales growth. Projections are for 733% EPS growth next quarter and over 100% sales growth. This is absolutely what you want to see in a leading stock.

At 14% return on equity (ROE), it’s a little shy of the 17% or more I’d prefer seeing, but it’s not bad. Institutional ownership has grown in the past few quarters, a great sign, and the relative strength (RS) line is at a new high – all fantastic. To top it off, it’s a leader in its industry group, which is running strong right now.

There’s much more to say about this company, but as usual, do your own background research. I have it on my watch list and am continuing with my research as I am deciding which few stocks I’d buy if the market enters a new uptrend.

Some Big Picture Perspective

We are now taking a break after a tremendous run-up from the bottom of the housing/financial bubble bear market, which is the 4th most severe bear in at least 100 years.

Much of the bounce off the bottom of this Panic of 2008 was a re-pricing of beaten down stocks from major investors who had priced in depression-level, worst-case scenarios in companies representing all sectors of our economy.

As it became apparent that we were not headed for a depression, the big money (mutual funds, pension funds, etc.), which controls over 70% of the money in the stock market, began entering the stock market once again. Many stocks did an about-face from their harrowing slides and headed upward, creating deep “V” shaped charts.

The stock market itself, represented here by the S&P 500 chart, shows a deep “V” shape to it.

For the individual growth investor, it was essential to wait for a clear signal off the bottom of the bear that the market was ready to go higher. There were so many abrupt bounces off of false bottoms through the bear market, that one had to be exceedingly patient for the bear market to exhaust itself.

The opportunity finally came shortly after the bottom of March 2009. One serious problem was that the economy was in such bad shape, it was difficult finding quality stocks. In a healthy bull market, one has a difficult time picking between several stocks showing tremendous earnings per share and sales growth. In the after math of a bear market, one has a difficult time just finding stocks that show strong earnings per share and sales growth.

Now that we find ourselves approaching a level just below the level in the stock market marked by the Lehman Brothers collapse, the number of healthy growth companies to choose from is much better than just a few months ago. Challenging older levels seems much more reasonably with better fundamentals.

We are in a correction, which provides an opportunity for growth stocks to set up in proper basing patterns, digest gains through minor corrections and shake out weaker investors, and hopefully run higher after a break out above pivot points.

Now is the time to be searching for fundamentally strong companies setting up in constructive technical patterns. I’ll be posting such companies here over the coming days.