Cabot Growth Investor Issue: December 28, 2023

Happy New Year

When I started my career at Cabot back in 1999—coming up on 25 years (!), which is a little scary—I saw the biggest bubble top ever, followed right away by one of the biggest bear markets ever, and I used to half-seriously say getting that education early on was a huge help. But, of course, the education process never stopped, and in the ensuing two decades I’ve seen many “never before seen” events, from a financial crisis to quantitative easing to 0% interest rates and even a pandemic.

The point: I’ve seen a few ups and downs over the years, but I can’t remember a time when we were heading into a new year with such exciting potential, for a few reasons. First, of course, our market timing indicators look great—the Trend Lines, Tides and Two-Second Indicator all continue to flash green, and a lot of secondary measures (Aggression Index, trend of interest rates, etc.) are in the same boat.

Second and just as important, this comes after two years where most of the market was in the wilderness; for growth stocks, most crashed and spent months (often up to a year) bottoming out. Indeed, we read today that, according to Bank of America, the big draw in 2023 was cash, with money market funds bringing in about nine times the amount ($1.3 trillion) of equities ($150 billion). In other words, it certainly seems like sentiment, which ground lower for two years, has turned up and still has plenty of room to improve.

And third is the fact that we’re seeing very unusual strength—so much so that it should portend higher prices ahead. While blastoff indicators haven’t worked as well as they normally do the past couple of years as the Fed tightened, when you combine the power with the above two points and other factors (like tons of individual stocks acting well), it looks like the best is yet to come.

Near term, of course, we’re not going to leave our brain at the door: Lots of things have had a very good runs in the market and leading stocks, and a lot of the worries from a few weeks ago have been forgotten. January is often a tricky month due to various crosscurrents (investors taking profits and repositioning portfolios), so we’re not advising anyone to go out and buy five or 10 stocks today.

But with the calendar about to flip, my main message is about the big picture: The stars seem to have aligned for a sustained bull phase, with big investors gobbling up top stocks as they look three to nine months ahead and see better-than-expected results. As always, if the evidence changes, then we’ll adjust our thinking, just as we have for the past few decades—but right now, it’s best to have a bullish bent and keep an open mind to the possibilities in 2024.

What to Do Now

Continue to put money to work, although we’re growing more selective in the near term. We held off buying last week, and tonight, we’re making one small move—buying a half-sized position in ProShares Russell 2000 Fund (UWM), leaving us with around 20% in cash. We could have some moves in the next couple of weeks if we can take advantage of any normal early-January volatility, but tonight, we’ll stick with the one move and head into 2024.

Model Portfolio Update

As we roll into the New Year, the market remains in a markedly different stance than it did when 2023 began—not only are the indexes headed up, but so are the vast majority of stocks, with hundreds of new highs and some rare “hyper-overbought” readings that, all else equal, should portend good things to come.

We’re not anxious to cannonball into the pool right here given the market’s run of late, a bit of sluggishness among growth stocks (they look fine but some have stalled out for the time being) and the fact that January is right around the corner—while not usually a bad month performance-wise, January is known for crosscurrents and volatility as some profit taking usually hits some winners and some big, nimble investors (think hedge funds) make a bunch of moves to get their portfolios where they want them.

That said, we’re also not going to ignore the very bullish intermediate-term evidence—tonight, we’re adding a small new position ( a half-sized stake in UWM), and if early January presents some reasonable wiggles, we’ll aim to put another slug of cash to work soon.

CURRENT RECOMMENDATIONS

Arista Networks (ANET)—ANET continues to act fine, holding just about all of its gains from earlier this month. While the networking sector has ebbs and flows, there’s no doubt the major demand trend is up as big cloud operators and enterprises need to increase speed and bandwidth over time. Moreover, there seems to be growing optimism that the AI boom is going to play into Arista’s hands; that might take a few quarters to really rev up, but if Ethernet is the preferred backbone, the upside here in late 2024 and beyond could be very big. As with everything else, a January wobble is certainly possible, but ANET did a great job of resisting the market’s downward pull in 2022 and 2023, and now the path of least resistance is clearly up. BUY

CrowdStrike (CRWD)—If we do see some reasonable weakness in growth stocks in early January, we could take advantage of it to average up in CRWD, which has acted about as smoothly as we could have hoped, with a tight area just south of 260 during the past couple of weeks. Interestingly, the CEO revealed last week that new regulatory requirements, which require firms to disclose any meaningful cybersecurity breaches, are helping CrowdStrike’s business, both in terms of hiring the firm to assess any damage and, of course, to possibly sign up those companies for its prevention offerings after the fact. As for the general environment, some investment houses see cybersecurity budgets booming 25% to 30% next year, and there’s no reason this company won’t grab more than its fair share. We’ll stay on Buy a Half but continue to look for a higher-odds point to average up. BUY A HALF

DraftKings (DKNG)—DKNG remains a near-term laggard, with its very promising breakout action in early November hitting a road bump this month, likely due to uncertainty surrounding competition (ESPN in particular). That said, we remain optimistic as the potential hasn’t changed—the firm thinks it will see EBITDA lift to north of $2 billion within a few years (up from a loss this year and an expected $400 million or so in 2024), and that’s just in the states that are currently legalized and assumes no market share gains; if online sports betting was theoretically fully legalized in the U.S., the company thinks there’s upside to $6 billion! If the stock really cracks the 50-day line, we’ll probably sell a chunk of our shares to respect the weakness, but at this point, we’re holding on and looking to see if the recent small bounce can gain steam, which would be a sign that the overall uptrend is resuming. HOLD

Duolingo (DUOL)—DUOL has flashed a bit of the volatility it’s known for this week, with a good-sized reversal on Tuesday—but as long as that volatility occurs above its moving averages (the 25-day line is around 225, with the 50-day at 200), the action is normal. The company remains quiet on the news front, which means many investors are likely looking for some update on the uptake of the firm’s newer math and music offerings (one of our good friends signed up for Duolingo’s music class after Santa brought them a guitar for Christmas). We’ll take it as it comes, but the massive-volume breakout to all-time highs on earnings and the solid action since portends higher prices down the road. BUY

Elastic (ESTC)—ESTC has been marking time during the past couple of weeks, which is fine by us—trading tightly after its gigantic post-earnings move is a good thing and is allowing the moving averages to catch up (25-day is up to 105). While the valuation isn’t cheap, we like the fact that Elastic has a great core business for data search (applicable for things like security and observability), and management made it a point to say it’s having tons of conversations and early uptake of some newer AI-related offerings, as its platform is perfectly suited to be the search engine that many AI systems are built on. If the stock falls apart, we’ll cut our loss and move on, but right now we’re thinking optimistically—a strong rally from here could have us filling out our position. For now, we’ll stay on Buy a Half and look for the stock to follow through on its rally. BUY A HALF

Nutanix (NTNX)—NTNX acts a bit like CRWD, extremely smooth to this point, with basically zero wobbles during the past few weeks (it’s up eight weeks in a row, a clear sign of persistent buying). That’s going to change at some point, of course, but the stock acts like a fresh leader after years on the outs (the all-time high for the stock was back in 2018)—and that makes sense given the firm’s move to a subscription model and an emphasis on its IT platform that can handle a big client’s entire IT stack, even across multiple cloud environments. The bottom line here is that Nutanix’s offering saves customers plenty of money and increases ease of use, so recurring revenue and cash flow should continue to kite higher in the quarters to come. We’ll stay on Buy, though as with many names, try to buy on dips of a point or two. BUY

ProShares Ultra Russell 2000 Fund (UWM)—Yes, the market’s had a big run of late, which means some sort of shakeout is possible—but, as we write about later in this issue, it’s also possible that the super strength we’ve seen of late in the broad market is telling us the past two years of muck is in the past, replaced by a “real” bull move. Combine that with the fact that small caps have spent years in the wilderness (the Russell 2000 saw no net progress from mid-2018 to October of this year; the index would need to rally 19% from here just to get back to its 2021 peak) and we think that area of the market could finally have its day in the sun. We’ll buy a half-sized stake (5% of the portfolio) tomorrow, use a loose stop (15% or a bit more from our entry) to give the position room in case we do see a pullback—and look to average up if the buyers remain in control. BUY A HALF

PulteGroup (PHM)—It’s fairly well known at this point that the trend in interest rates (and, hence, mortgage rates) has turned down—but what’s not as talked about is the “damage” also being done to the long-term uptrend in rates: In fact, Treasury rates across the board (two-year, five-year, 10-year) are now clearly below their 200-day lines and we’re even starting to see some of the 200-day lines turn down. We’re not going to predict what happens from here, but there’s little doubt that the move should charge up an already-resilient housing market (after a 25%-ish dip from the peak, the number of housing starts bottomed out for months and is now perking up; November’s figure was up 9% from the year before). That means Pulte’s buoyant business should strengthen and that earnings estimates (analysts see earnings next year of $11.31 per share, down 2% from this year) could prove conservative. (Earlier this year, analysts saw Pulte’s earnings coming in around $8 per share, which tells you how fast the numbers can move.) Obviously, a backup in rates could pull down PHM and other homebuilders for a bit, but the main trend is up. Hold on if you own some, and if you don’t, you can start a position here or (preferably) on dips. BUY

Uber (UBER)—If a stock runs higher before inclusion into a major index like the S&P 500 (due to investors front-running the huge index funds that have to get in), you’ll usually see some retrenchment, and we’re still thinking that’s possible with UBER—but so far, the stock’s resilience and tightness despite its big advance has been impressive. The top brass has been mostly quiet the past few weeks, but it’s clear that big investors think that the core businesses here should see strong (and if the economy picks up, accelerating) bookings while some newer ventures (like the advertising business, which could bring in $1 billion in 2024) lift off and EBITDA and free cash flow power ahead. We think higher prices are likely down the road, though if you’re starting a position today, you might consider keeping it small and/or looking for dips of two or three points. BUY

Watch List

• Blackstone (BX 133) or KKR (KKR 83): Both of these Bull Market stocks are acting well as investors anticipate their cash flows booming with easier money and rising asset prices. See more below.
• Cloudflare (NET 85): NET is probably our favorite “old” leader, with a story that should produce rapid (30%-ish top line) growth for a long time to come as profits and margins (pre-tax margins of 18% in the latest quarter) surge.
• Eli Lilly (LLY 582) and Novo Nordisk (NVO 104): We suspect we’ll find out soon whether these two stocks have simply been playing possum after big runs in the summer and fall; NVO has actually perked up near its price highs of late (though both stocks’ RP lines are short-term lagging). We’re looking for decisive, big-volume rallies to signal the rest period is over.
• Gitlab (GTLB 65): We don’t want to get too tech- and software-heavy in the portfolio, but Gitlab is a name we’ve been watching for months due to its big story, growth and, now, surging profits. Shares continue to act well following their big-volume breakout in early December.
• Expedia (EXPE 153): EXPE isn’t a true growth stock, but the exceptional power it’s shown of late tells us something is going on. Business here is growing nicely, cash flow is enormous and estimates will probably prove conservative. The first shakeout should prove buyable.
• Shift4 (FOUR 75): Some of FOUR’s strength of late is due to buyout rumors, but as we’ve written repeatedly, the underlying story here is outstanding, with a very solid 2024 outlook by management presented on the Q3 call bringing in some big fish. Some modest weakness would be very tempting.

Other Stocks of Interest

Broadcom (AVGO 1120)—As we wrote in our watch list a week ago, we know $1,000-plus stocks aren’t anyone’s favorites out there, but we usually don’t put a ton of emphasis on a stock price (we’ve seen tons of higher-priced names do just fine; institutions, which are the ones that drive stocks, don’t care about the price). Plus, there’s one lesson we learned long ago: Never underestimate a super-liquid, big-cap stock that breaks out on out-of-this-world volume … which is just what we’ve seen from Broadcom of late. The firm has its hands in most chip (about 60% of revenue) and tech infrastructure (40%) cookie jars that play into just about every theme out there (networking, servers and storage connectivity, broadband, wireless, industrial, automotive, etc.) thanks to both in-house development and a slew of good-sized acquisitions over the years, with the latest being VMware (which just closed in November). As you’d expect, then, this is a giant operation—in the fiscal year that ended in October, Broadcom cranked out $35.8 billion in revenue, up just 8% from the prior year, as many of its cyclical chip end markets struggled, and the coming year should see more single-digit growth. However, the stock has gone bananas for a couple of reasons. First, this has always been a very, very profitable company; pre-tax profit margins in the latest quarter were 59% while free cash flow made up nearly half of revenues for the entire fiscal year! And that’s expected to continue going ahead—management sees EBITDA up nearly 30% in the coming year despite the slow revenue gain as VMware helps and other profitable areas kick into gear. Second, while many firms talk a good AI game, it looks like Broadcom is already seeing real results: Within its chip business, nearly 20% of its revenue last quarter was at least somewhat related to generative AI (including its AI accelerators, where it’s a firm second place to Nvidia), and the top brass sees that leaping to 25% for the current fiscal year as a whole (which implies the figure should likely hit 30% by year-end 2024). All in all, you have a very well-situated company with a strong history of topping estimates that’s a leading player in some new, big growth areas, with strong cash flow growth likely for at least the next couple of years—the combination of which is like catnip for institutional investors. Indeed, AVGO exploded higher during the initial AI boomlet in the spring, and after leveling out for a few months, has seen overwhelming buying of late, including its heaviest weekly volume since 2018. Yes, it’s higher priced, but our guess is AVGO will do well going ahead.

UiPath (PATH 26)—We already have a couple of fastballs in the Model Portfolio, so we’re not sure we’ll go for another recent big earnings winner that moves around a ton—but if we were going to do that, UiPath might be it. The company isn’t a household name, but it does a good business in automation software, helping clients (especially good-sized ones, where it’s shifted its focus in recent quarters) to do things like intelligent document processing, filing forms, updating databases and even programming manufacturing robots on assembly lines, among other things; all in all, the platform helps streamline various processes, and that provides clear benefits, saving firms plenty of time and money. That’s led to an increasing number of big firms in tons of industries signing up and using UiPath’s platform across all sorts of departments (HR, finance, IT, you name it), and Uncle Sam is quickly joining that list (Coast Guard, IRS, Veterans Affairs and Dept. of Homeland Security and Dept. of Agriculture; the U.K.’s largest public service department is also on-board). Of course, automation and AI go hand in hand, which is leading to both better capabilities for UiPath’s platform and greater interest among potential and current clients, and after a year of tightening budgets, many are thinking growth could surprise on the upside going ahead. In Q3, sales continued their accelerating trend (up 24%, 19%, 18% and 7% the past four quarters) and earnings (up 140%) crushed estimates while recurring revenue lifted to $1.38 billion (also up 24%) and same-customer revenue growth was north of 20%. Even without any change in the environment, UiPath should grow nicely for a long time to come—but, obviously, the market is expecting things to improve in 2024, which could create a torrent of demand for the firm’s offerings. The stock imploded during the bear market and bottomed out for about a year before catapulting higher on its Q3 report—and shares have actually nosed higher since then with any little wobble bringing in buyers. The valuation is up there (nearly $15 billion), but we’re impressed that more than 650 funds own shares, a figure that’s been increasing steadily. It’s volatile, but PATH has a very solid story.

Blackstone (BX 133) and KKR (KKR 83)—As we write later in this issue, there are more and more signs that the market’s late-year rally might be more than that—possibly the start of a real, sustained bull phase following two years mostly in the wilderness. If so, it’s about as sure a bet as they come that Bull Market stocks (those whose business benefits from higher asset prices) like Blackstone and KKR will thrive. Both firms have good-sized private equity operations, as well as plenty of assets in real estate, credit and, for KKR, insurance as well. In fact, that seems to be one of the differences here (and a reason why, while both stocks look good, KKR is stronger): KKR recently bought the rest of insurance outfit Global Atlantic it didn’t already own for $2.7 billion, which management expects to boost both fee-related and distributable earnings per share by 10% in 2024. Back to the bigger picture, assets have remained solid at both firms, but growth has slowed to mid-single-digit rates as asset prices struggled and sentiment waned (making it harder to raise money)—but if the Fed really is off the market’s back, money becomes easier next year and the economy doesn’t implode, that should all change, which will lead not just to higher earnings but bigger payouts and share buybacks as well. There’s not much sexiness to the stories, but it’s a straightforward idea that has worked very well during prior sustained uptrends, and we see no reason it won’t repeat if the bulls really have taken control. As mentioned above, KKR is a stronger situation, so we slightly favor that one, though BX is the granddaddy of the group; they both look attractive and are on our watch list.

“Hyper-Overbought” Readings Are Usually a Good Thing

The market is a contrary animal, as it often behaves in a manner that is the exact opposite of what common sense says should happen. And because of that, a lot of what we focus on is how the market actually works—not how it’s “supposed to” work based on preconceived notions. A great example of this is when the market gets very overbought or oversold.

It turns out that when the market gets very oversold, which can be measured in a variety of ways, including breadth, price action and more, it does tend to occur near market lows. Not necessarily to the day or week, but in the ballpark so to speak. However, when the market gets very overbought—what we call hyper-overbought—it’s not a bad thing. In fact, it’s usually super bullish!

This all comes down to what famed technician Walter Deemer said: The market gets most oversold at the lows but gets most overbought at the start of a new advance. Even better, “new advance” often means a new, sustained uptrend that runs for many months if not a year or two. (While too late for stocking stuffers, Mr. Deemer’s book “When the Time Comes to Buy, You Won’t Want to,” is a nice addition to any library—it’s a brief collection of market truisms and clever sayings.)

On December 19, more than 90% of the S&P 1500 (small, mid and large caps combined) closed north of their 50-day line. That’s only happened a dozen other times since 1980, and the S&P 500’s average maximum gain a year later was more than 23%, with the average max loss of just over 2%. Interestingly, for the small-cap Russell 2000, the results were even better, with a much larger average max gain during the following year (over 32%), albeit with more volatility (5% average max loss).

Moreover, these results overlap somewhat with our Small-Cap Surge indicator, which also flashed recently (December 14): The Russell 2000 closed more than 13% above its 50-day line (again, hyper-overbought) and was coming out of a correction (was below its 200-day line sometime in the past three months). That’s only happened five other times since 1987, and all were excellent entry points: May and November 2020, April 2009, June 2003 and February 1991. Again, it’s only five instances so you it’s not all encompassing, but a year later, the max gain for small caps averaged 40%! (Shown below are the 2003, 2009 and 2020 signals alongside the iShares Russell 200 Fund, symbol IWM.)

Adding to the intrigue are some other very rare overbought measures that have also only occurred at these same super-bullish times. According to Ryan Detrick of Carson Group, we recently saw more than 40% of the stocks in the S&P 500 see their RSI close over 70 on the same day (RSI is an overbought/oversold measure, with 70 usually considered overbought). Since 1975, that’s only occurred at bull market blastoffs like early 1975, October 1982, February 1991 and the summer of 2020.

Also, according to Jason Goephert of SentimenTrader.com, the equal-weight S&P 500 (symbol RSP) just cycled from a new 52-week low to a new 52-week high in just 33 trading days. Since 1957, the only faster turnaround came in … September 1982.

These blastoff-type indicators obviously have a terrific history … but to be fair, some of them either failed or led to less-than-pristine action during the past two years as the Fed and interest rates ran the show. As always, there’s no such thing as a perfect indicator, so we’re always keeping our eyes open for a change in character.

But the fact that we’re seeing (a) some very rare, hyper-overbought measures flash green right now, (b) many of these have pinpointed starts of major bull moves, and perhaps most importantly, (c) this isn’t happening in isolation, as the market’s other evidence (Trend Lines, Tides, Two-Second Indicator) and action of leading stocks are all pointed up.

None of this means the short-term won’t see some wobbles given how far the market and many stocks have come, but the point is that the collection of evidence is growing that the market isn’t just strong now but may have turned the corner into a real bull phase after two years in the muck. Because of that, we’re starting a position in a leveraged long index fund for small caps (UWM—see more earlier in this issue) and will look to add more if the bullish vibes continue.

Cabot Market Timing Indicators

Our market timing indicators couldn’t look much better as we roll into the New Year, and the fact we’re seeing some hyper-overbought measures flash green adds to the intermediate-term good vibes. Of course, after two months of rallying, we could see some short-term hiccups, and January is often a tricky month, but all in all, the bulls are in control.

Cabot Trend Lines: Bullish
Our Cabot Trend Lines turned positive in January and, after surviving a couple of scares (March and October), remained bullish for the remainder of the year—and head into 2024 in great shape, with the S&P 500 (by 8%) and Nasdaq (by more than 10%) well above their respective 35-week lines. Combined with many other pieces of evidence, it bodes well for the months ahead.

Cabot Tides: Bullish
Our Cabot Tides are also clearly bullish, as all five the indexes we track (including the S&P 500, daily chart shown here) well above their lower (now 50-day lines). At some point, of course, we’re going to hit some near-term potholes in the indexes, but there’s plenty of room to correct and consolidate without damaging the intermediate-term uptrend.

Two-Second Indicator: Positive
Our Two-Second Indicator has recorded just one plus-40 reading since mid-November, with the readings since the Fed’s latest meeting drying up nicely. As a heads up, the indicator can get a little funky around the flip of the calendar as lots of big, nimble investors (like hedge funds) make a bunch of moves, which is something to keep in mind—but overall, there’s no doubt the broad market is in good health.

The next Cabot Growth Investor issue will be published on January 11, 2024.