Cabot Growth Investor Issue: December 14, 2023

Overall Strong, but Watch for Rotation

While technically not a total surprise to the market, yesterday’s Fed meeting was certainly noteworthy: After two years of worrisome inflation, jawboning and, of course, tons of rate hikes, the Federal Reserve didn’t just hold rates steady again but officially said their members expect three rate cuts next year. Of course, those are just guesses, but it’s led to a tizzy in the stock and bond markets the past couple of days.

Stepping back and just focusing on the evidence, not that much has really changed—our Cabot Trend Lines, Cabot Tides and Two-Second Indicator are all positive, and the same goes for our Aggression Index. Moreover, the trend in rates, which has been the tail that’s wagged the stock market since late 2021, remains sharply down, with the Fed’s outlook driving all sorts of Treasury rates to new lows and even below their 200-day lines!

Moreover, it’s hard to be certain until the final figures come in, but today’s action may have triggered something of a blastoff signal, with 90% of the S&P 1500 stocks (big, mid and small caps) closing north of their 50-day lines, which historically happens early-ish in larger upmoves. Overall, then, we’re encouraged, and continue to put money to work—tonight we’re doing just that, averaging up on one name and starting a stake in another.

That said, we also have been writing that we’ve seen a few short-term yellow flags out there, with many junky stocks rallying strongly (a sign of speculation) and growing numbers of new highs (good overall, but another near-term sign of exuberance)—and today, while the good news is out, we saw many growth leaders pull in or lag. No breakdowns, mind you, but some rotation could be starting.

What to Do Now

Is that a reason to change course? Not for us—the rubber-meets-the-road intermediate-term evidence is most important and remains bullish—but we are content to move gradually given growing short-term risks (and few stocks that are great entry points). Tonight in the Model Portfolio, we’re going to fill out our position in Arista Networks (ANET) and start a half-position in Elastic (ESTC), buying 5% positions in each. Our cash will total about one-quarter of the portfolio after the moves.

Model Portfolio Update

The market remains in very solid shape, led by (what else?) the leading stocks—to this point, not only have the ranks of leadership improved, but as some have finally hit some resistance, the rest periods haven’t been like the last couple of years (when sudden air pockets were the norm), with tight, controlled retreats, and with many stocks (including some we own) refusing to pull in at all, instead surging to higher highs.

Now, as we’ve been mentioning for a couple of weeks, the near term is getting a bit giddy—there have been many junky stocks perking up, and this week saw a multi-month high in the number of new highs (for the S&P 500, we saw the largest number of new highs in two and a half years). That’s a good thing in the intermediate term (more participation), but along with some junk stocks working and some rotation, there’s definitely an increased risk of retrenchment.

Still, while that’s something to watch and a reason to pick our spots and stocks carefully, it’s not a reason to ignore the positive overall evidence, including our bullish market timing indicators. Tonight, we’re going to average up in Arista (ANET), which is off to a solid start, and start a half-sized position in Elastic (ESTC). We’ll now have about one-quarter in cash after these moves.

CURRENT RECOMMENDATIONS

Arista Networks (ANET)—Arista’s management essentially confirmed that 2024 should see a slowdown from the torrid growth rate seen in the past two years, brought about by some cyclicality from the giant cloud operators that are getting past the upgrade to 400-gigabit devices, but are still not quite at the point where they’ll ramp to 800-gigabit stuff. However, the stock remains strong, partly because of hints the firm’s growth outlook is conservative (it usually is, and the top brass said they see at least a couple of different ways they can hit their current targets; while cloud sales are slowing, enterprise growth remains vibrant) and because the writing is increasingly on the wall for AI-related revenues to ramp late next year (the top brass said $750 million likely in 2025, but again, could be conservative). With the stock stretching higher, we’re going to fill out our position tonight, buying another half-sized stake (5% of the portfolio) and using a stop on the combined position in the mid-190s, which will keep risk in check should the market pull in. BUY ANOTHER HALF

CrowdStrike (CRWD)—Well, CRWD has gotten away from us on the upside since earnings, which is why we’re still sticking with a half-sized position. Of course, that’s a “good” problem to have (something we own that’s running higher), and we’re not anxious to simply chase it higher at this point; a controlled dip of a few percent as the moving averages catch up could have us buying more, but for now, we’ll just hold what we have. Encouragingly, the cybersecurity group has gone from OK to one of the strongest in the market during the past few weeks, with peers like Palo Alto (PANW), Zscaler (ZS) and even smaller SentinelOne (S) all tagging new high ground in recent days. We think CRWD is the leader both technically and fundamentally, so we’re holding on tightly to what we have and could grab some more on normal weakness. If you’re not yet in, look to start a position on dips of five or 10 points, with round-number resistance near 250 possibly causing some selling. BUY A HALF

DraftKings (DKNG)—While not abnormal, DKNG did have a sloppy stumble last week, with some heavier-volume selling coming in on no specific news … though it did occur around the time that management was asked about ESPN Bet at a conference. They did make it a point to say all is well (“we watch this stuff very closely and we’ve seen nothing to suggest that our trajectory is changing”), but management also said “this is a competitive market and we’re going to continue to have to fight for the customer and build great product,” which some might see as a sign a turf war could re-emerge. What do we think? In general, that the Wild West days in the industry are gone, so the leaders like DraftKings should remain in good shape. Today’s reversal was again sloppy, and a drop below the post-earnings close near 34 (and near the 10-week line) would be iffy and could have us taking action—but right here, with most of the evidence in the bull camp, we’re staying on Buy. BUY

Duolingo (DUOL)—DUOL has been all quiet on the news front since earnings, when it announced results and (for iOS users) released an updated math course and new music courses, in addition to more than 40 language courses, boosting hope that the firm is becoming more of an online learning platform. We don’t have any estimates, but we imagine taking even a small slice of (or expanding the market of) the math tutoring or music private lesson “sectors” could be enormous. We’ll see how it goes, but in the meantime, we’re impressed with the stock’s action—shares are always tricky, but so far the stock has held its massive earnings move and, this week, moved to new price and RP highs on good volume. We’ll stay on Buy. BUY

Elastic (ESTC)—We’re always cognizant of having the right balance of volatility in the portfolio—we don’t want too many “fastballs” as we call them, because when a correction or even shakeout comes in growth stocks, the dips can be vicious. DUOL is one very volatile name we own, but we’re also going to add Elastic, which began to turn itself around in September and then, on earnings two weeks ago, had a coming out party as it’s looking more likely that the firm’s search offerings (really for Big Data applications) will end up being key cogs in upcoming AI systems for big enterprises. Of course, AI revenues are still something that will come down the road, but even with its traditional Big Data business, its solutions are popular for data analytics, which is why growth is solid (17% revenue growth) and earnings are taking off (37 cents per share in Q3, up from a penny the year before and 12 cents above expectations), with analysts seeing 34% bottom-line growth next year (likely conservative). There’s obviously risk as the stock had a big move, but we’re thinking the recent earnings surge is likely a kickoff to better things ahead and the stock’s latest mini-exhale looks fine. We’ll buy a half-sized position (5% of the portfolio) and use a loose loss limit (15% to 20% below our cost) for now. BUY A HALF

Noble (NE)—From a market-wide perspective, the weakness in oil stocks (they’re pretty much the worst thing out there next to solar names) is probably a good thing, as energy is usually a “late cycle” trade (occurs closer to the end of a market move, not leading from a bear market). Obviously, though, that didn’t help Noble, which showed a couple of promising bounces, but the decline in oil prices has dragged the stock below its long-term 40-week line. Eventually, it’s very likely the years-long dry times in the offshore drilling sector will lead to boom times due to reduced supply of rigs, and who knows, maybe the bounce of the past couple of days is the start of something. But there’s no doubt the trend is down for NE and the group as a whole; we sold what was left of our stake last week. SOLD

Nutanix (NTNX)—NTNX continues to act pristinely, notching new highs fairly regularly and with only modest dips on down days. Of course, with the 50-day line south of 40, like so many names, a shakeout or rest period wouldn’t surprise, especially if we see some post-Fed rotation. But, overall, it’s looking like the stock’s big breakout September 1 may have kicked off a longer-term advance, as the firm’s leading IT platform is seeing increased adoption and the subscription model (lifting recurring revenue and free cash flow) is paying dividends. Hold on if you own some, and if not, aim to start small on dips, ideally of a couple of points. BUY

PulteGroup (PHM)—While not a total surprise, yesterday’s Federal Reserve meeting had the members forecasting three rate cuts next year, which has helped the bond market rally further (10-year Treasury yield below 4%)—and that’s likely to both drive mortgage rates lower and aid in overall economic growth, both of which are obviously good things for homebuilders. Even before the latest dip in rates, Toll Brothers’ (TOL) recent earnings report (for the quarter ended October) effectively confirmed demand remains solid in the sector. As for Pulte, analysts see earnings remaining elevated ($11.25 per share) next year, but the thought is that even that will prove conservative as conditions improve. We averaged up on our position last week and shares have taken off this week as rates cave in; periodic dips aside, we think PHM (and the group as a whole) should see higher prices. BUY

Uber (UBER)—UBER has been strong since the market bottom, but news that the stock is going to be added to the S&P 500 next week (news was announced December 1—UBER will be in the index prior to the open next Monday) has sent the stock even higher. That said, it’s worth noting that a stock will often pop before the actual addition (as we’ve seen) but then sag somewhat afterwards; no guarantees, of course, but it’s a decent bet we’ll see some retrenchment. Still, the stock should be underpinned by the fundamentals we’ve written about many times, with strong demand and massively expanding EBITDA and free cash flow margins (and with EBITDA making up just 3.1% of gross bookings in Q3, there’s plenty of upside potential). We’ll stay on Buy because the big picture remains very positive, but we’re half-expecting some dips next week. BUY

Watch List

• Cloudflare (NET 85): Most old leaders are still languishing, but NET looks like a survivor, with great growth trends and a massive opportunity. See more below.
• Datadog (DDOG 121): DDOG remains a leader in the massive and growing observability trend—while growth has slowed, it should remain solid while profits and margins are buoyant.
• Dave & Buster’s (PLAY 51): PLAY has a very interesting turnaround and growth angle, and the stock is waking up after a few rangebound years. See more below.
• Eli Lilly (LLY 574): LLY has been lagging the rally and it’s always possible today’s selling may bury the stock. But we feel there’s a chance it could be playing possum as the potential for its weight loss and Alzheimer’s drugs is immense. See more below.
• Expedia (EXPE 147): EXPE seems like a classic situation that was left for dead by the market due to macro concerns but has now completely changed character as earnings and cash flow are huge and growing while management is buying back tons of stock. And if the Fed’s easier stance gooses the economy, all the better.
• ProShares Ultra Russell 2000 Fund (UWM 37): As we write later in this issue, small caps have been essentially dead money for five and a half years, so if we have started a sustained bull phase, UWM could have plenty more upside (though maybe after some near-term retrenchment).
• Samsara (IOT 36): The valuation is definitely up there, but it seems like a good bet that Samsara is destined to become much, much bigger as its cloud platform targets many enormous firms (those with tons of physical machines) and even government departments to save them huge time and money. The latest breakout attempt (its third) could be the charm, though so far it’s been wobbling since last week’s surge.
  

Other Stocks of Interest

Cloudflare (NET 85)—Having lived through a few big down cycles, we’re seeing a common pattern emerge from many of the prior big winners (in this case, from the pandemic), with most of those stocks still suffering to some extent, both on their charts but also fundamentally—the DocuSigns, Teladocs, Bill.coms and Zooms of the world aren’t acting like leaders in the stock market and most are growing only modestly at this point. However, a choice few past winners, like Datadog (DDOG—written here last issue) and Cloudflare, are continuing to execute flawlessly, with huge potential if they continue to pull the right levers. Cloudflare has always had a big, pervasive idea: It runs one of the world’s largest Internet networks with a presence in more than 300 cities that connect 13,000 other networks (the scale is huge, with Cyber Monday’s peak levels seeing more than 100 million requests per second across its network), offering tons of different services that help clients have a faster, more secure, more reliable, more efficient and more private Internet experience—it’s not really a competitor with public clouds (like Amazon’s AWS or Microsoft’s Azure) but is more of a “connectivity cloud” that allows firms’ various devices to better connect to whatever they want to online. The offerings are super popular (more than 182,000 paying customers, up 22% from a year ago), including big firms (more than 30% of the Fortune 1,000 are signed up; clients paying at least six figures annually are up 51% from a year ago), and the opportunity here is about as big as it gets, with Cloudflare’s various application, security, network and developer offerings targeting a market well north of $100 billion annually. Despite tech spending issues, the top brass here has steered the company in the right direction, and while growth has slowed a bit, it remains rapid—revenues in Q3 were up 32% from a year ago, analysts see 28% growth in 2024 (almost surely conservative) and earnings have been in the black and growing nicely for at least the past eight quarters. Fundamentally, we think the company is relatively rare merchandise, and the longer it can grow at healthy rates, the more big investors will stay interested and/or build positions. Indeed, after a year of wild bottoming action, NET had a more controlled dip in the summer and fall and, this week, popped above resistance near 80, hitting 15-month RP peaks in the process. We’re intrigued that NET may have morphed from a hot glamour name to a liquid leader.

Dave & Buster’s (PLAY 51)—We’d love nothing more than to see a great, growth-oriented (preferably cookie-cutter) retail story thrust into the market’s leadership … but at this point, those are rare and tend to be well-known names. That said, turnaround-type retailers are doing well, with many shaking off supply chain and cost issues to see earnings soar and their stocks respond. Dave & Buster’s is a very interesting turnaround play that also has decent growth prospects as the ship is righted: The firm operates 159 namesake locations that feature lots of games with a pub-type food and drink environment (popular with adults and older families), as well as 58 Main Event locations, which is similar but caters to younger (families with kids) cohorts. The Main Event business was added via a big acquisition in 2022, and interestingly, the combined firm is using Main Event’s management team to shake things up—Dave & Buster’s recovered well from the pandemic, but organic growth has been lagging for a while, so the new team is containing costs, tweaking marketing and looking to expand in the years ahead. Indeed, earlier this year, the new top brass laid out a big store expansion plan (to 550 eventually and to 250 within a couple of years) that, along with cost controls and efficiencies, should double EBITDA from 2022’s level to 2025. Moreover, it thinks cumulative free cash flow during 2022-2027 would total something like $40-plus per share even if current locations showed zero growth! Sure, long-term projections aren’t always reliable, but the top brass clearly believes them—it thinks the stock, which has been waterlogged since early 2021, is a bargain, buying back 17.5% of shares so far this year (!). Even better, Wall Street is expecting growth to perk up in 2024—analysts see earnings up 27% this year and 21% next, and the stock is starting to change character, racing out above multi-year resistance this week. We like that Dave & Buster’s is a differentiated offering (not just another restaurant) with a proven management team (they had great success with Main Event before the buyout) with a stock that’s been left for dead—but is now starting to wake up.

Eli Lilly (LLY 574)—Lilly fascinates us for a few reasons, the most obvious of which is that it could be sitting on what turns out to be the biggest-selling drug in history: The firm’s tirzepatide treatment (marketed as Mounjaro for diabetes and, after approval last month, as Zepbound (daily injection) for weight loss) could easily have many millions of patients on it within a few years—even in Q3, the drug was the firm’s second-largest seller (bringing in $1.4 billion of revenue, up more than seven-fold from a year ago) as diabetes and off-label weight management prescriptions went bananas. And some see that figure eventually reaching $52 billion annually! That’s the big draw, no doubt, but Lilly is obviously not a one-trick pony when it comes to irons in the fire—it recently received approval for an ulcerative colitis drug, which some industry watchers think can become a $1.7 billion drug within five years; and in Q1 of next year, the company’s Alzheimer’s treatment (which significantly slowed cognitive decline in early symptomatic patients during trials) should get approval, with those same industry experts thinking that drug could top $7 billion in revenue down the road. To be fair, this week saw some so-so news—Zepbound patients who stopped treatment ended up gaining back a lot of weight, which may play into insurance decisions (health insurance firms may be less willing to shell out big money for months and years on end). Even so, the writing is on the wall here that the drugs (and Lilly’s other newer offerings) are going to help the company’s profits surge; already, the bottom line has been rising nicely, with Wall Street seeing $12.30 per share or so next year (up about a third from this year, adjusting for some one-time items). That said, the stock has sat out the rally, albeit after doubling from its lows in March of this year—though even after today’s poor action, it’s less than 10% from its highs and has given back just a fraction of its gains in recent months. As we wrote a few issues ago, the question is whether the stock has discounted most of the good news here … or whether LLY is playing possum, simply digesting its prior rally while building strength for its next move. Simply put, if the stock fades from here, we’ll avoid it, but a couple of big-volume up weeks could kick off a powerful upmove. We still think it’s worth watching (but not buying) here.

Is It Finally Time for Small Caps?

In the last issue, we wrote about some medical and biotech names, thinking that, should the market rally, that group—which has lagged for years—could finally kick into gear. We’re still watching the group and many stocks to see if big investors take an interest.

Along the same line of thinking is not a sector, but a big segment of the market that we may look to invest in soon—small-cap stocks. This year, of course, with so much of the action until recently concentrated in just a few names, small-cap indexes have lagged badly. But what’s eye-opening is that this isn’t just a 2023 phenomenon: Shown below is the monthly chart of the S&P 600 SmallCap Index, and as of the end of October, the index was essentially retesting its bear market lows from last year. Moreover, the S&P 600 at that time was actually a few percent below its peak from August 2018 … more than five years of no net progress!

To be fair, small-cap indexes have a bit of a built-in “lagging” bias over time. Why? Because the best performers “graduate” to become mid-caps or large caps, and thus are swapped out of one index and into another. Meanwhile, the mundane performers stay in the small-cap index—basically, the index loses its winners and holds onto its losers, which is the opposite of proper portfolio management.

That said, it’s not like small-cap indexes are permanently bad performers—in fact, over many decades they’ve generally done better than their larger-cap peers. And, following bear markets, small caps have a history of outperforming, too; sure enough, we’ve seen the S&P 600 and the Russell 2000 Fund (symbol IWM) rebound smartly and actually outperform the big-cap indexes a bit since the lows.

All of that brings us to the ProShares Ultra Russell 2000 Fund (UWM), which moves twice the Russell 2000 Index (percentage-wise) up or down, each day. As we’ve seen with the leveraged long fund that tracks the S&P 500 (SSO), these funds can be a great, relatively low-stress way to ride a bull trend—but when things head south or chop wildly for a while, they can obviously turn against you.

The real question is something every investor is asking: Is the bump seen since the start of November “just” a year-end rally, or is it the start of a sustained advance that can carry on for months—a new bull phase? We’re not big into predictions, but with our intermediate-term indicators looking as good as they have in a couple of years, we’re leaning optimistic—we may start with a half-sized position in UWM soon and look to buy more if the market and small caps continue to head higher, which itself would add to the odds a “real” turn up has come.

The (Lack of) Action in Defensive Stocks Remains Encouraging

Short term, there remain some signs the market (or, via rotation, some growth stocks) could be ready to hit some potholes—maybe the most notable is the rush into some (not all) junky stocks. We’re talking about names that were taken out and shot during the bear market, languished this year, and have poor fundamentals … but are still seeing their stocks rally 30%, 50% or more in a matter of a few weeks as traders pile in. Beyond Meat (BYND) is a good example, with the stock imploding to new lows in October, with shrinking sales and big losses, but the stock has popped hugely from oversold levels. (Usually these pops don’t last long.) It’s a sign that speculation is picking up, which usually doesn’t happen at the very start of a rally.

That’s worth keeping in mind, but while speculation can be a heads-up that things could hiccup in the short term, we like to see if big investors are changing their tune. The most important way we see that is via the action of leading stocks—so far, most leaders continue to act in a pristine way, which is obviously a plus, not just running higher but holding or building on their gains.

Just as encouragingly, we’re not seeing any big movement in defensive names. While the consumer staples fund (XLP) is headed up, it’s certainly not exploding higher or outperforming most of the market, which would be a warning. Indeed, that fund, which in our view is the best representation of defensive stocks, isn’t making headway versus the Nasdaq, which keeps our Aggression Index (Nasdaq vs. XLP) positive.

The point here is that, short term, there are signs of enthusiasm that could lead to some wobbles in the market or among leading stocks—but intermediate term, there aren’t many signs big investors are either bailing or starting to run for safety.

Cabot Market Timing Indicators

We may be starting to see some rotation in the market, which could take some steam off the super-hot growth stocks. That’s something to note, but big picture, the intermediate-term evidence remains excellent, with all of our key indicators (and some other important measures) positive.

Cabot Trend Lines: Bullish
There’s nothing new to say about our Cabot Trend Lines: They remain clearly bullish, surviving the shakeout from late October and skyrocketing since then. After many months of what was effectively bottoming action (following the 2022 downtrend), the long-term trend is strongly up.

Cabot Tides: Bullish
Our Cabot Tides are also bullish, with all five indexes we track (including the NYSE Composite, shown here) well above their lower (now 50-day) moving averages. Obviously, after a big run in November and this week’s moonshot, some backing and filling is possible, but there’s no question the intermediate-term trend is up, and thus the odds favor higher prices in the weeks and months ahead.

Two-Second Indicator: Positive
The weakness in oil stocks caused one day of more than 40 new lows this week, but one day is not a trend—and now we see the readings shrinking ahead as the Fed has supercharged the market. That keeps our Two-Second Indicator bullish, telling us the broad market is in great health.

The next Cabot Growth Investor issue will be published on December 28, 2023.