While the history and precedent examples we’ve laid out over the last few months continue to play out, now is no time to get sloppy. The true leading stocks have likely shown their faces by this point, so we now have our work cut out for us. Harnessing these stocks at proper entry points is the way to make massive gains in an investment portfolio. Based on their fundamentals and their current action, ARM Holdings (ARMH) and LinkedIn (LNKD) appear to be the true market leading stocks. We must study them closely to see if this trend continues through the eventual bull market top. In the coming sections, we’ll put the action of both stocks under a microscope to evaluate how they are behaving.
With the current bull uptrend now 3.5 months old, we’re starting to get a bit extended, and sentiment has been reaching bullish extremes. A short pullback or even sideways trading for a month or two at this stage wouldn’t be uncommon. “The market will serve to either wear you out or scare you out” is a common quip. As we move steadily toward the eventual bull market top (likely in the next 6 to 12 months), enough pessimism persists in the mainstream investment community to indicate institutional investors have yet to resolutely dive into the market. Prices should continue to power higher over coming months, but as always, we let market action itself dictate how we invest our portfolios. Let’s jump into our analysis on February’s action.
Indexes
Our first pillar of market health is the actual day-by-day action of many broad indexes. We look at (in order of importance) the Nasdaq, S&P500, NYSE, and the Dow Jones Industrial Average as our primary gauges of market health. The Nasdaq is the most important index because the young, upstart growth companies in America tend to list their shares on this index, and these companies in turn are the ones that power the U.S. to new levels of innovation and value creation. Similarly, the S&P500 is a broad measure of business activity across 500 of the largest and most reputable companies in America. Both should be watched closely and their individual action should be held above all other indexes.
For the month of February, the Nasdaq rose 0.6% while the S&P500 closed the month up 1.1%. The Nasdaq made a fresh bull market high in February, reaching 3213.60 on February 19th, only to reverse lower and close the month at 3160.19. It appears the 3200 level is acting as a ceiling at the moment; round numbers can often act as either a ceiling or floor, depending on the nature of the market move. Meanwhile, the S&P500 set a new bull market high of 1530.94 in February, before closing the month at 1514.68. As of February 28th, the S&P500 sits 4.1% below its all-time high and 2007 bull market peak of 1576.
Despite solid progress through most of February, both indexes began mounting heavy distribution late in the month and appear to be ready to begin a pullback. A typical pullback would be somewhere between 7-10 weeks, just long enough for stocks to correct and shakeout some of the excessive optimism that accompanied the year’s start. The indexes appear to be executing a short-term topping pattern and could begin a correction anytime. A typical pullback would be 8-12%. With both indexes making fresh bull market highs, a solid move down could help pave the way for later bull market gains. If no pullback manifests, sideways trading could set in, which would also cause most investors to forget the market has been making new highs. Both alternatives are constructive.
It’s important to remember that in March, we are entering the 5th year of the bull market that began in March 2009. Historically, bull markets don’t often last longer than 5 years. Gauging the action of many leading stocks (which we’ll discuss in the next section), we are currently in the middle innings of the final push towards a bull market top. Stocks that have distinguished themselves with strong fundamentals and superior technicals are the ones to focus on into a bull market top, as excessive optimism usually leads to prices being bid up to extreme levels in these companies.
Overall, after strong gains in February, an investor would be wise to take any gain where sitting through a normal, short-term pullback would be uncomfortable. The Nasdaq has largely been weighed down by Apple, but that’s no excuse for its overall action. Many young, fresh companies are seeing institutions accumulate their shares and these companies could one day replace Apple as the dominant company on the index. With the overall market in a correction mode, it’s time to take our foot off the gas, take some gains where we have them, and begin to build our watch lists to look for the next crop of stocks to power the market higher. By the time April rolls around, we could be poised for a fresh new uptrend. Keep your watch list ready! A correction is no time to get sloppy. The market can change direction in as little as 4 days.
Leading Stocks
Our 2nd pillar of market health is to follow the stocks with the best fundamentals in the marketplace. These are the companies providing innovative solutions to drive productivity and serve people across the globe. We at Satellite Capital look for the following fundamentals: large and accelerating quarter-over-quarter earnings and sales growth (preferably 25% QoQ or higher), high returns on equity (preferably 20% or higher), solid 3 and 5 year earnings and sales growth rates (preferably 25% or higher), high levels of cash flow generation relative to yearly earnings, and some product or service that is innovative and is enriching the industry in which the company plays.
As you could imagine, given our preference for the large numbers stated above, the universe of stocks in which we’d want to invest dwindles quickly. It’s rare to find a stock exhibiting all the above criteria to the highest level, but they do exist. For stocks that don’t meet all of the above criteria, which are the majority of all stocks listed on U.S. exchanges, striving to invest in companies that meet as many of the above criteria as possible is key in outperforming averages in a rising bull market.
Leading stocks in February largely continued upward off of breakouts over the last 2 months. A handful of stocks have made powerful gains in massive volume, demonstrating to us true leadership status (in alphabetical order): ARMH, CELG, LNKD, & QIHU. The latter (QIHU) has seen 4 straight quarters of earnings and sales deceleration, which gives us some cause for concern, but the overall action of the stock is very positive. CELG ran up 20% in just a few weeks and had lately been holding tight right around the $100 level. Back in the early 1900’s, Jesse Livermore famously observed that when stocks finally clear large round numbers, they tend to run up 20 or 30 points from that round number. CELG moved above the $100 level in big volume on February 28th and is acting well as of this writing. It is definitely a stock to watch closely.
Both ARMH and LNKD have made spectacular gains from their respective breakouts (ARMH up better than 50% since late October 2012 and LNKD up 50% since its breakout on January 10th this year). These 2 stocks have come under extreme institutional accumulation and have great stories behind their market leadership. LNKD will be discussed in the History & Precedent section below.
ARM Holdings designs the majority of low-power, high-performance semiconductors installed in mobile devices and tablets all around the world. ARMH has been dominating Intel in the space and continues to increase its market share. Rather than physically making the chips themselves, ARMH designs the chips and leaves production to low cost semiconductor manufacturers like Taiwan Semiconductor (TSM). The company has excellent fundamentals, is under solid accumulation, and even closely mirrors the action of a stock from the not-too-distant past: “History doesn’t exactly repeat, but it often rhymes” is a Mark Twain-ism that we truly believe in the stock market. A closely rhyming story for ARMH is Research in Motion (RIMM), today known as Blackberry (BBRY), during the 2002-2007 bull market. Remember, we don’t buy solely based on historical precedent, though we do allow precedent to guide us as to how a leading stock may perform. Strict rules and discipline remain the keys to investing success.
In any bull market environment, an investor’s job is to identify those stocks that could be true market leaders based on both fundamentals and technicals, and then to find proper entry points in order to aggressively build positions in those stocks. Once a true market leader or leaders have been identified, we need to do as little trading as possible to let the position play itself out. At the end of a bull market, we strive to have our biggest positions be in the true market leading stocks. In this likely final year of the bull market that began in 2009, both ARMH and LNKD are currently behaving like the stocks that institutions have to own because of their superior growth stories, amazing fundamentals, and top-notch technicals. We recommend you watch both stocks closely over the coming 6 to 12 months.
Overall, the true leaders have likely broken out and moved by this point, so your watch list is likely as small as ours. At this stage of the game, it comes down to position management and weeding your portfolio to maximize the efficacy of dollars invested by identifying your best performing positions. The optimal way to start a rally is casting a wide net and then pruning back as market action dictates further investment. Most leaders appear to be fairly early in their move, and several have recently tested their 10 week moving averages (successfully), which is usually a sign of pause before continuing higher. We need to remain alert to any emerging changes and resist complacency about the progress realized since the November 16th low.
Sentiment & Psychology
Our 3rd pillar of market health is to examine market sentiment and psychology. Understanding market sentiment and investor psychology is secondary in importance behind following the action of the indexes and that of leading stocks. Various gauges of sentiment and psychology are helpful when many indicators are at extremes. When indicators are at moderate levels, less useful information can be gleaned. No one indicator is better than another, and a good analyst will maintain a dashboard of many indicators to help them effectively evaluate the market. At key turning points, many of these indicators will be telling the same story and flashing similar signals (both positive and negative depending on our location within a market cycle).
As of February 28th, the NYSE Advance/Decline line is still holding near highs despite choppier market action. One key divergence that we’ve noted is that a 10 day moving average of stocks making new highs didn’t move into new high ground, while markets did move higher. This demonstrates a bit of weakness as the 3.5 month rally begins to age. Similarly, the percentage of stocks above key moving averages (20-50-100-200 day) have all begun to back off the extreme levels reached earlier in February. While not a sign of impending doom, it does give us some cause for concern as overall market breadth is weakening. Our stocks are saying things are otherwise fine, but we need to be cognizant of the environment in which we are investing.
Sentiment gauges have also retreated from extreme levels as of February’s close. Both AAII and Investor’s Intelligence have seen a bit more bearishness enter their ranks, which is good for an eventual upturn. When everyone is bullish about the market, there is generally no one left to buy and push prices up further. Given supply and demand, when there is no demand because everyone who wants to buy has already bought, any amount of supply coming onto the market will depress prices. This is how bull market tops are formed. While we feel we are not yet to a bull market top, the stage is being set for one to appear over the next 6 to 12 months. Our job is to interpret the day-to-day market action during this final rally period and to position ourselves in leading stocks at proper entry points.
Overall, secondary indicators are giving a slightly more bearish tone than they were at the start of February. While not a justification to sell, it’s an item we have to closely monitor. If further distribution mounts on the indexes, we need to scale back positions of stocks without significant gains and wait for proper patterns to emerge.
History & Precedent
Our 4th and final pillar of market health is examining history and precedence. This is the least important of the other 3 pillars listed above, but can often provide insights into the action of the market that may resemble prior periods of market action. History repeats itself whether we like it or not, and those who forget history are doomed to repeat it.
This month, we’re going to take a different spin on things and examine a stock performing very similar to another leading stock in history. In 1996, Yahoo (YHOO) went public and proceeded to shed 64% from its IPO entry point. After falling, the stock eventually rallied up to its IPO high and built 2 unique patterns. The 1st pattern was wide, loose, and relatively flawed. The 2nd pattern was much tighter and demonstrated the stock was under accumulation. After breaking out of the 2nd pattern and into all-time high ground in July 1997, the stock shot off like a rocket and ran up over 580% by the time a short bear market started in July 1998, just 12 months later.
The key to this stock’s success was that it had something new generating a lot of money for shareholders. In the mid-to-late 90’s, the marketing dollars Yahoo generated as a result of its search algorithm were powering the company’s shares. The internet was at that time a nascent technology offering millions of people access to data across the web, and many follow on leaders were poised to emerge over coming years as this technology became more mainstream and more productive uses for it were found.
Compare the Yahoo example with another internet sensation today, LinkedIn (LNKD). LinkedIn is currently dominating the social/business networking scene in an economy where people are just now getting serious about searching for jobs. After the ‘Great Recession’ from 2007-2009, many employees were unwilling to forfeit steady jobs in hopes of securing new or better paying jobs. As we progress further and further from the crash, and as companies perform better and better every quarter, employees’ flexibility continues to increase.
LinkedIn is the tool to help individuals connect with colleagues, recruiters, companies, and ideas. The company’s biggest revenue is currently generated via recruiters who pay a fee to search out and contact qualified candidates that match what their firm is looking for in an employee. The second biggest revenue generator for the company is targeted advertising sales on its various pages. And the third way LinkedIn generates money is by selling premium memberships that allow users to send an unlimited number of messages to other users, and to see who has been viewing their profile.
LNKD is clearly the dominant player in its field. When set and compared to the Internet Content group, LinkedIn and Facebook (FB) are the dominant players in the social networking space. But LinkedIn has the unique ability to fit into another space as well: the staffing arena. When we examine LinkedIn, we also look at stocks like ManpowerGroup (MAN) and Robert Half (RHI), which have made stellar gains since the market bottomed on November 16th (both up better than 40% during a time when the Nasdaq was up just under 15%). During the same period, LinkedIn is up over 80%, demonstrating its pure dominance.
Comparing the above LinkedIn chart to that of Yahoo after its IPO, there are many similar repeating elements. First, LinkedIn came public very much in the media spotlight, never good for an individual stock or the market as a whole. From its IPO, LNKD sold off 54.3% before starting its current move up. Imagine the public’s attitude toward a stock like LNKD after seeing its shares drop by over 50%; public investors in large weren’t paying attention to the stock, and have thus far missed out on the big gains generated since it bottomed in December 2011.
The stock rallied sharply after setting that bottom, carrying it all the way to the high it set during the first week of its IPO in May 2011. As is common with stocks that have gone public, the stock found resistance at its prior high and built a wide and loose consolidation pattern (marked as the sloppy pattern #1 above). The stock then broke out of that pattern in September 2012, just as the market was shifting into a downtrend.
From September 2012 through January 2013, LNKD built a much tighter pattern with more accumulation and many indications of heavy institutional buying. The stock initially broke out of its pattern on January 10th, almost a full month before its earnings announcement on February 8th. The handle was a bit low for this pattern, but another handle pattern emerged right at the top of the overall pattern, before the earnings announcement. This was a good hint that the stock was setting up to power higher. From January 29th through February 7th (8 days), the stock drifted down near its all-time highs before exploding 21.3% on February 8th, the 1st trading day after its earnings announcement.
For the quarter, LinkedIn announced diluted earnings that grew 192% quarter-over-quarter, matched by sales growth of 81% quarter-over-quarter. The stock has top notch fundamentals and sports a 3-year growth rate of 190%. This is the type of stock that institutions absolutely have to own. Since emerging from its $117.42 initial entry point, LinkedIn is up 49.8% and is still climbing in increasing volume. If you compare this action to that of Yahoo’s above, this stock could be in for still bigger gains.
To close this section, we can’t be positive if the precedent described above will continue to play out. All we can do is closely observe the market’s action and that of LNKD as described above. If LNKD continues to drastically outperform, this stock could be one to add to the model books. The stock is currently behaving like a true market leader, as described with ARMH in the Leading Stocks section above. When identifying and investing in these true market leaders, we must utilize rules that govern how aggressively we enter a position and over what time period. We never buy off historical precedent alone. Rules. Rules. Rules.
Conclusion
In summary, a crop of leading stocks with strong fundamentals and technicals has emerged and broken out of early stage patterns over the last 3 months. Our job now is to balance and position our portfolios among these great growth companies. It’s still possible other leaders could emerge, but as we’re likely in the middle of the final run to the bull market top, we feel the true leaders have likely already emerged (see the Leading Stocks section above). If the market continues into a correction in March, we should be vigilant about watching these and other potential leaders to position ourselves accordingly when a new uptrend finally resumes.
Until then, we absolutely must be diligent about keeping our watch lists fresh and staying on top of our day-to-day analysis. The key to big gains is shifting money toward ideas that are already working for you. Identifying a core group of positions and weeding underperforming positions to feed those that are performing is the way to make life changing gains in any bull market environment. As we kick off March 2013 and the 5th year of the bull market that began in 2009, time left in this bull market is running out quickly, and the big gains are likely to be made within the coming 6 to 12 months.