Market Comment

When the Music Stopped

October 2, 2011

“A man who carries a cat by the tail learns something he can learn in no other way.”
                    –Mark Twain

Market participants who decided to play the long game in the wake of the August lows scramble to find a seat now that the music has stopped.

In our last report of Sept. 27, we sniffed at the three-day bounce which came on uninspiring volume. This was punctuated on the last day of the rise when the market, once again, allowed negative European news to unsettle it.

And herein has been the chief dilemma for the market: How to continue its seven-week advance without the participation of its most important sponsor, the large player.

The view here has been that when you take away a lot of stimulus, in fact the most since the ‘Thirties, if ever, and the stimulus did not do much to stimulate job creation, it is plausible to expect recession.

The following two charts are of our two favored economic data points. They are forward-looking indicators, unlike the monthly employment report. The first shows an obvious drop-off in the last two months. A level below 50 denotes a contracting manufacturing sector, which has a good correlation to overall economic growth.

The chart below also shows a general worsening, last week notwithstanding.

With that said, it is not our job to read the tea leaves of the economy and then plot investment strategy based off of it.

Of critical import is the market’s reaction.

The advance in the averages off the August 9 lows appeared to have some substance. This was borne out by about two dozen growth stocks building, and then breaking out of, bases on their charts.

But two things were suspect. First, there were hardly any major accumulation days in the averages. Second, leading stocks did not follow through on their breakouts by moving up 20%-25% or more.

Both developments spoke of one thing: The institutional participant had not yet committed to playing the game.

Among the names, Apple (AAPL) has been the title, along with Baidu, that we have felt offers the most compelling look at institutional sentiment at the margin. Thus, its weakness is disheartening, if not a surprise.

Pricesmart (PSMT), with six quarters of revenue acceleration, forfeits all of its gains post-breakout amid three distribution days.

Amazon.com (AMZN), a one-decision institutional favorite expected by most analysts to record 63% earnings growth in ’12, broke out of its base on volume 97% above average. Follow-through was subsequently lax, and the stock dropped back into its base.

Chipotle Mexican Grill (CMG), which had shown some constructive action on the right side of its base, came out but was turned back on the following day.

Ulta Salon (ULTA), which on Sept. 9 had shown activity of 426% above its average daily volume as it approached the top of its base, lost traction within a week and now sits 16% off its high.

Watson Pharmaceuticals (WPI), compared with most other leaders, has held up well, owing to its high level of earnings stability and low sensitivity to the economic cycle.

Other of the growth stock glamours show the same pattern of breakout followed by failure.

Baidu (BIDU) we mentioned as being a short candidate in the last report. A day later, it became obvious to more participants, and price plunged amid reports that the SEC and Dept. of Justice may investigate the accounting practices of Chinese firms listed on US exchanges. From Wednesday’s open, when our report came out, to Friday’s low, price dropped nearly 21% before finding buyers just north of par at 100.95.

Big-winning stocks in a bull market, especially those selling at elevated price-earnings multiples, often are big losers in the ensuing bear. With this in mind, depending upon one’s risk tolerance, a holder of a short position in BIDU could either lock in half of the gain thus far, and let the rest of the position ride, or play the entire position out for a larger gain. The current resting spot above par may hold for a while due to the psychological importance of the round number and the recent stiff downdraft.

One thing to keep in mind is that, seasonally, more market bottoms are put in during the September/October period than any other. Whether this plays out this year is not known, nor is it worth losing sleep over. More important is to simply judge the market’s character and health on a daily basis, keeping an open mind as to what could happen.

Flexibility may be the most important ingredient in successful speculation. Certainly it is an advantage that the individual participant has over the institutional player.

Elsewhere among market-leading growth titles followed in these reports, nothing is holding up. Everything is breaking down. Apple and Amazon may be holding up better than younger names, but they are all being unwound as market participants ponder an economy that weakens as Europe burns.

In summation, the Nasdaq had been the strongest of the major averages. For the seven-week share advance to have any hope of survival, the Nasdaq’s rebound early last week needed to hold. The first two days of its rise came on light volume and the third was turned around on negative Euro-news. Following this came three days of selling. As we wrote late Wednesday in another report, continued breakdowns in the leaders would represent the final nail in the coffin.

This has transpired and the dirt is now being shoveled on top of the grave.

Kevin Marder

Gil Morales & Company, LLC (“GMC”), 8033 Sunset Boulevard, Suite 830, Los Angeles, California, 90046. GMC is a Registered Investment Adviser. This information is issued solely for informational purposes and does not constitute an offer to sell or a solicitation of an offer to buy securities. Information contained herein is based on sources which we believe to be reliable but is not guaranteed by us as being accurate and does not purport to be a complete statement or summary of available data. Past performance is not a guarantee, nor is it necessarily indicative, of future results. Opinions expressed herein are statements of our judgment as of the publication date and are subject to change without notice. Entities including but not limited to GMC, its members, officers, directors, employees, customers, agents, and affiliates may have a position, long or short, in the securities referred to herein, and/or other related securities, and may increase or decrease such position or take a contra position. Additional information is available upon written request. This publication is for clients of Gil Morales & Company, LLC. Reproduction without written permission is strictly prohibited and will be prosecuted to the full extent of the law. ©2008-2017 Gil Morales & Company, LLC. All rights reserved.