April 7, 2022

The market’s evidence improved under the surface for much of February and early March, with the strong rally last month only adding to the good vibes. A pullback wasn’t unexpected, but so far, the way things have retreated hasn’t been encouraging, with a lot of potential leaders taking it on the chin and our nascent Cabot Tides buy signal back on the fence.

To be fair, the decline hasn’t cracked the uptrend in the market or most stocks, and a couple of good days would do wonders. But with few stocks really making headway, we advise going slow, adhering to your stops and holding a good chunk of cash.

Earlier this week, we sold one of our recent buys, and while we have no new sells tonight, we are placing a couple more names on Hold and have relatively tight stops in place in case the selling continues.

Market Overview & Model Portfolio Update

Sellers Still Lurking
As we’ve written a few times recently, even though the major indexes were looking ragged through early March, there were many under-the-surface positives (bullish divergence from the number of new lows, etc.) out there, and then the buyers showed up, with a strong rally right off the lows that trigged a rare Four-Day Frenzy signal, with our Cabot Tides following that up with a green light a few sessions later.

All in all, the rally was impressive, with the Nasdaq recouping well over half of its losses (57%) during that short time, while the S&P 500 actually regained three quarters of what it had lost! Of course, it wasn’t all sunshine (there was still a lot of selling on strength in individual names), and after the move, a pullback was certainly due—but how things pulled back would be revealing.

And so far, the action on this retreat has been … not great. Pushed along by a barrage of hawkish Federal Reserve talk, the major indexes have slid sharply, with broader measures (small- and mid-cap indexes) cracking intermediate-term support. Worse has been the action of individual stocks, with many of the best-acting growth names from a month ago getting hit the hardest, including a good amount of abnormal action.

On a positive (or less discouraging) note, despite the horrible headlines (recession talk is quickly becoming the norm, and if anything, sanctions overseas are going up, not down), all of the good vibes from the February bottoming process and March rally haven’t been negated. Our Cabot Tides are still technically positive despite the air pocket (though the next few days will be telling there), while many stocks are wounded but not broken. Plus, as we expand upon in this issue, a retest (or partial retest) of the lows isn’t unusual following the Four-Day Frenzy signal—we’re not downplaying the pain that would cause, but bigger picture, a sustained run is still a decent bet to emerge down the road.

Thus, we’re not fully reversing course at this point; in fact, we think some of our recent purchases can be winners if any sustained advance that develops. However, we’re also not going to ignore what’s in front of us—an environment where the sellers are still lurking and very few stocks are letting loose on the upside.

What to Do Now
After months being mostly on the sideline, we put a chunk of money to work as things improved, but stuck to half-sized positions and kept 45% in cash. With the recent weakness, we’re focused on kicking out things that really give up the ghost while holding names that are resisting the renewed selling wave. In the Model Portfolio, we sold Globalfoundries (GFS) earlier this week, giving us around 50% in cash; tonight, we’re placing a couple more names on Hold and have tight stops in place in case the selling continues.

Model Portfolio Update
The rally that got underway in early March got off to a great start and followed weeks of bottom-building evidence, and from there, a pullback of some sort wasn’t unexpected given the sharp run from the lows. But it’s fair to say the severity of the recent drop isn’t what you’d see if the market were about to kite higher, with the indexes and growth stocks sinking quickly driven by waves of bad news (both overseas and from a super-hawkish Federal Reserve).

As we wrote above, not all is lost despite the past few days, with a few rays of light from our market timing indicators and, when it comes to growth stocks, there are still a bunch that have been attempting to bottom out for weeks. However, at the same time, there’s no question that few stocks really got going during the rally, with most that poked their head up near new high ground being soundly rejected (in fact, the best-looking names early in the rally have been hit the hardest). Plus, defensive stocks have been percolating, and let’s not forget our Cabot Trend Lines are still bearish, which is definitely a headwind.

We bought a few half-sized positions during the upmove, but kept 45% in cash, and as always, our goal is to prune names that crack but give resilient performers a chance to hold up. We sold GFS earlier this week, leaving us with 50% in cash; we’ll sit tight tonight, but we’re placing ANET and PSTG on Hold have relatively tight mental stops in place should the selling wave intensify.

Current Recommendations

Arista Networks (ANET)—ANET is an unfortunate example of what we’re seeing out there during the past trading days: The stock was one of the few in growth-land that had a “normal” correction during the first two and a half months of the year, and when the pressure came off the indexes, it quickly spurted back toward its highs. But then came yesterday, with the stock gapping down sharply on big volume … raising the prospects of a big double top in the chart. Overall, ANET still looks better than most growth stocks (heck, it’s still above its 25-day line), so it’s not like all hope is lost. But the question is, with a possible retest (or partial retest) of the market lows underway, are sellers going to come around for stocks that have “meat left on the bone,” meaning they have avoided the worst of the selling in recent months. We’re not going to overreact to one day, but given the stock’s action and the market, we’re return to a Hold rating; at this point, we’ll be using a mental stop in the low 120s, though the next few days will be key. HOLD

CarGurus (CARG)—Fears of an economic slowdown or recession obviously aren’t a good thing for CarGurus, whose business is, at least in some respects, tied to the health of used auto sales. Still, while the swings in CARG have been wild, we think it’s holding up fairly well compared to its recent range—shares are above their levels from the start of this rally (near 37.5) and above the 50-day line (near 39), and volume in general has been light as the stock has chopped around. Obviously, if the market continues to keel over, all bets are off, but we think more big investors are coming around to the view that the firm’s CarOffer segment is an emerging blue chip in and of itself, replacing old-school, inefficient auctions and allowing all the small fries to be able to buy used cars from consumers directly. (The number of funds owning shares leapt from 418 at the end of September to 490 at year-end and has likely grown from there.) Plus, chart-wise, we’d note that the first huge gap on earnings (as CARG enjoyed in February) usually isn’t the last. Long story short, our eyes are obviously peeled given the renewed selling in the market, but so far, the stock’s action is reasonable; if things stabilize, we think shares can do well. A drop into the 37 to 38 range would have us abandoning ship, but right here, we’re holding what we own; if you don’t own any and have lots of cash, we’re OK buying a small position. BUY A HALF

Devon Energy (DVN)—DVN has eased a bit during the past couple of weeks, partly due to the market and, of course, because of some wild swings in oil prices, which chopped lower in a volatile fashion during the past few days. We’re open to anything, of course—we took partial profits a few weeks ago and have been on Hold since, recognizing that the spate of “good news” (for oil prices) and the big runs in the stocks could lead to a meaningful correction. That said, we have to say that we’re impressed with the recent resilience: Despite recession worries, Fed hawkishness and lots of jawboning (including the release of a chunk of the strategic reserve), current oil prices remain in the mid $90s, and contracts even a year out are still hanging around $88. And that obviously means the prospects for a bunch more beefy dividends and lots of share buybacks are high and increasing. If you don’t own any or have just a small amount, we wouldn’t argue with a nibble around here—DVN is inching down close to its rising 50-day line (now near 56), which has (mostly) contained its multi-month run. That said, officially, we’ll remain on Hold a bit longer and see how the stock (and the sector) handles itself in this environment. HOLD

Dutch Bros (BROS)—At some point, we think BROS is going to have a very solid, sustained rally, bolstered by a fantastic cookie-cutter story and some of the best store economics we’ve seen (about an 80% payback in year one) in our years of researching these types of companies. Given the stock’s resilience early in the year and strength when the market got going, we thought that time was now—but the quick reversal lower casts doubt on that. To be clear, we think most of the “problem” right now is the market itself; the greater investment spending Dutch is planning to make this year (including into ground leases, which are more expensive up front but have lower costs over time) could cap earnings growth during the next two or three quarters, but none of that prevented the stock from acting relatively well (compared to most growth stocks) in recent months. Whatever the case, BROS’ attempted multi-month breakout above 60 has failed, and the action of late has been discouraging; that said, the stock is still holding just north of support (in the 48 to 50 range) and there should be support in this area (where the stock was bottoming out from December through February). Long story short, we’re sticking with BROS, but it’s on a very tight leash; if all is well we’d expect buyers to jump in right quick. HOLD

Globalfoundries (GFS)—We always go back and look through our prior trades (usually after a few weeks or months to let the dust and emotions settle) and look at a few things—first, how the trade did, but equally important, what, if anything, could be improved upon in the selection. In the case of GFS, the results speak for themselves; we cut bait earlier this week when the stock tripped our loss limit and dipped below its 50-day line. Still, in all likelihood, we’d take the same trade again if the circumstances repeated: GFS had the story (long-term contracts + expanding capacity = great growth for at least three years going forward), numbers (big sales and earnings results and estimates) and chart (including big buying volume that drove the stock to new highs soon after the market got going) that suggested it was starting a big run; in our mind’s eye, such a trade will work seven times out of 10 times, and one or two of those will likely morph into bigger winners, too. Don’t get us wrong, that doesn’t excuse the loss—it debited our account just like any other sour trade—but simply to say we think the stock’s recent implosion has mostly to do with the overall market and the sector (ON was another potential chip leader that’s bit the dust). Either way, we think GFS’s recent slide will take time to heal; if you still own some and want to try to sell on a bounce, that’s fine, but we’re out and believe the damage done of late is abnormal. SOLD

Palo Alto Networks (PANW)—PANW is one of the only growth stocks that still looks very good, with higher lows during the correction (a new high after earnings in late February, in fact), a strong bounce to new highs last month and decent resilience since. There’s no secret sauce here, just a well-managed cybersecurity player with top-notch, next-generation products that serve firms building systems for hybrid work and also serving those with “hyperscale” cloud operations. A big attraction here is the buoyant free cash flow as well; Palo Alto has guided free cash flow for this fiscal year (ending in July) to around $1.77 billion, or north of $18 per share, which is more than double expected earnings. As with everything else, we’ll see how the stock does, but at this point, it certainly acts as if it wants to go much higher if the market can find its footing. Hold on if you own some, and if not, we’re OK stepping into a small position here or on dips. BUY A HALF

ProShares Ultra S&P 500 Fund (SSO)—While individual stocks have taken some big hits in recent days, the damage to the S&P 500, while not minimal, has been more controlled, giving up “only” 40% or so of its post-bottom rally, and the Cabot Tides green light has yet to be reversed. Stepping back, a partial retest of the March lows could be underway, but (a) we can’t conclude that at this point, and (b) even if it that happens, it wouldn’t be out of character of what happens following Four-Day Frenzy signals. That said, we never favor just holding and hoping—if the evidence deteriorates, we could trim back some of the additional SSO shares we recently bought. Just going with what we see now, though, we still think the odds favor the market being in a bottoming area of sorts, so we’re holding what we own—and if you want in, we’re OK starting a small position around here. BUY

Pure Storage (PSTG) has gotten clonked this week, and we’re not complacent—some other stocks that were at or near new high ground have cracked, so it’s possible this one follows suit. But so far, we think the decline looks more like a normal shakeout than an abnormal breakdown—shares are still well above their 50-day line, not to mention above the decent earnings gap seen in early March, just before the market low. Plus, after years of no progress in the stock, the company’s accelerating transition to a subscription model (read: more reliable growth) should attract more big fish; if the market does find its footing, we think PSTG can do very well. All that said, we’re not going to ignore the action of the stock or the market, so with our quick loss, we think it’s prudent to switch to a Hold rating and use a mental stop right around 30 (give or take a few dimes). HOLD

Watch List

• Inspire Medical (INSP 254): INSP bottomed at 195 last month, raced ahead to 270 and is currently in the 250 area despite the air pocket in the market—not bad at all. It’s thinly traded (just 265,000 shares per day, on average), but we could take a nibble if it holds up here and the market finds its footing.
• Halozyme (HALO 42): Old friend HALO looks to be turning the corner after a year-long correction and consolidation. The story remains as good as ever; see more below.
• Lantheus (LNTH 60): For all the news-driven market and sector movement of late, LNTH is a breath of fresh air, as its new diagnostic imaging agent for many prostate screens is allowing the stock to dance to its own drummer—LNTH remains perched near new highs.
• Nutrien (NTR 104): Speaking of news driven, NTR and other fertilizer-related names certainly are; any peace rumors usually hit the stock for a few hours, while sanctions help. Net-net, the sellers haven’t been able to make a dent, and more are coming around to the view that earnings are going to be enormous this year, and even if they backslide after that, should remain elevated for a long time to come. CF Industries (CF) and Mosaic (MOS) are two other possible plays.
• Shockwave Medical (SWAV 214): As you can see from this watch list, many medical-related firms are in position to help lead the next sustained advance—SWAV still has work to do, but its snapback of late, huge earnings growth (not just sales) and big story remain intriguing. See more below.

Other Stocks of Interest

Halozyme Therapeutics (HALO 42)—Halozyme has always had a story that was easy to love, and now, after a long, tedious decline, investors are looking ahead to what should be years of strong, high-margin earnings growth. The company’s main attraction is called Enhanze, a drug delivery technology that breaks down some cellular barriers in the skin that usually prevent bulk fluid flow; that allows for safe, rapid absorption of large amounts of therapeutics, which in turn results in a far quicker treatment time (minutes vs. hours) and is thus able to be given in less-intensive settings. Halozyme has licensed Enhanze to many big fish in the sector (J&J, Bristol-Myers, Argenx, Roche, Takeda, Alexion), which give it milestone payments and royalties as the Enhanze-related version of its drug hits the market. It has already has a couple of blockbusters on its hands, with Darzalex (by Janssen, a division of J&J, for the treatment of multiple myeloma) and Phesgo (by Genentech, a division of Roche, for certain types of breast cancer), and growth from these and other current indications should be strong for the next few years—but that’s just the start, as Halozyme sees another three potential blockbusters hitting the market by 2025, including Efgartimod by Argenx, used to treat an autoimmune disorder called Myasthenia gravis; analysts think the drug could have north of $2 billion of revenue by 2026 (Halozyme gets a single-digit percentage royalty in most cases). Because of the lumpiness of milestone payments, Halozyme appeared to stumble last year, but royalty revenue did great ($204 million, up 130%!), management sees more of that in 2022 ($300 million or so, up ~50%) and believes that figure could grow more than three-fold from there to $1 billion by 2027. To be fair, there are some patent worries when looking out a few years, but the top brass here insists it isn’t an issue for a couple of reasons (including the fact that many partner products are patent protected for a long time to come, not to mention a well-established safety profile and even a new enzyme that could extend protection) and Wall Street seems to agree: HALO saw its relative performance (RP) line bottom in December, and the stock has pushed back above its 200-day line and acted very well since the market low. It’s not strong enough for us yet, but shares certainly seem to have changed character. While not the main factor, a modest P/E (21 times earnings) doesn’t hurt the cause.

Wolfspeed (WOLF 101)—What if you had a business that was effectively sold out for years to come, and where growth was solely dependent on how quickly you could expand capacity? That’s basically the situation that Wolfspeed finds itself in today. The firm used to be known as Cree, but it sold off its now-commoditized LED business and has focused on a new, rapidly growing niche, with chips that use silicon carbide (SiC for short) instead of plain silicon; without getting into all the details, SiC chips are smaller, have less heat loss and convert energy more efficiently, making them must-have’s for many emerging areas like electric vehicles (where there are many applications), solar and wind power systems, industrial motors and more. The problem: There’s not much capacity out there, partly due to the newness of SiC, but also because of know-how; for instance, there aren’t any companies that sell SiC crystallization furnaces, so a firm has to build them itself! The attraction with Wolfspeed is that it was ahead of the game on all this—it broke ground on what will be the largest SiC-focused plant in the world two years ago (in Mohawk, NY; it’s just starting production tests, with major output starting later this year). And partially because of that, clients who want guaranteed production in the years ahead are signing up like mad. In the past two quarters, the firm scored a whopping $2.1 billion of “design-ins” (its chips will be designed into products; 75% or so of that total was for EVs), up 70% from the year prior and that compares to $613 million in revenue during the last 12 months! Wolfspeed is even considering pulling the trigger on a second massive production plant because, as mentioned above, even the capacity from the Mohawk plant could be sold out sometime in the next few quarters. Because of that, competition (there’s plenty) shouldn’t be an issue for years, with the big lever here being execution—if the top brass can get capacity ramped up in a timely fashion, there’s no reason the company can’t grow many-fold from here. Indeed, the firm believes revenues can reach $1.5 billion in fiscal 2024 (ending June) and $2.1 billion by fiscal 2026, with margins going through the roof (up 15 to 20 percentage points!) as the new plant gets to work. It’s a good story, but now we need to see the stock kick into gear—it tried back in October, but the market’s decline yanked it back down, and it showed good strength off the recent market low ... before again being pulled back in. As the go-to player in SiC, we think the stock could become an institutional favorite once a sustained market rally gets going.

Shockwave Medical (SWAV 214)—Shockwave Medical was one of the small(er) medical outfits we mentioned a couple of times last year (unfortunately we didn’t pull the trigger on it) and it had a huge run—only to fall 50% during the recent growth stock debacle. Is the overall run over? We don’t think so; oftentimes these young growth stocks have a “re-set” decline that wipes out all the weak hands and refreshes the long-term uptrend. The story certainly suggests the stock hasn’t seen its best days: Shockwave has come up with a new standard of care to treat calcified arteries, which is (a) obviously a growing market as the population ages and (b) isn’t served well by current treatments, with balloons ineffective and atherectomies (procedures to remove plaque from arteries) come with steep learning curves for doctors and carry risks of perforations and artery blockages. Shockwave has taken an old, proven technology called lithotripsy (been used for decades to eliminate kidney stones) and applied it here, using an inserted catheter that blasts sound waves to crack apart the calcium. It’s been proven to work better than other treatments, with a better safety profile, too, and because it’s not hard to train physicians, the uptake has been rapid—the firm already had approval for peripheral arteries coming into last year, but won approval for coronary applications in early 2021 (market of six million procedures annually!), which caused revenue to explode. Q4 saw sales up 271%, with coronary products making up about three-quarters of revenue, and earnings actually came in at 34 cents per share, with huge profit gains expected going forward. As reimbursement levels improve, the sales force grows (both here and overseas; the firm just started selling in the U.K and France in Q4; Japan coronary sales should start in late 2022/early 2023) and new products are released, Shockwave is going to get much bigger. To be fair, the stock could easily need more time and have more wobbles after its humungous 2020-2021 rally, but we think SWAV’s big rally (it recouped more than 70% of its decline) of late bodes well. It’s on our watch list.

Another (Partial) Retest Could be Underway
In the last issue, we spent a lot of space on this page writing about the big gains that historically followed a Four-Day Frenzy signal (four straight days of 1% gains in the S&P 500, which triggered on March 18) or its cousin, the Three-Day Thrust (three straight days of 1.5% gains). Depending on how you slice and dice the numbers, the S&P 500 averaged a maximum gain of 14% to 16% within just six months, with gains rising to 24% to 32% looking a year out. It’s just one indicator, of course, but we still believe the Four-Day Frenzy tell us to be open to the possibility stocks will be surprisingly higher in the months ahead.

However, near term, we also wrote that, you’ll often see another partial or full retest of the recent market lows within a couple of months of these signals. Digging deeper, what we’ve found is that when the S&P 500 closes below its 200-day line at the time of the signal (as it did this time, barely), it’s not unusual to see backing and filling within the next couple of months—sometimes including a partial or full retest of the lows. Conversely, when the signal comes above the 200-day line, drawdowns are less predictable, with many having none at all.

Numbers-wise, when the signal came under the 200-day line, the first three months saw an average drawdown of 5% to 6%. For example, take a look at 1974 (first chart below)—a Four-Day Frenzy triggered in mid-October (red arrow), and there was some buying after, but then came another tough downturn that tested the prior low. T

The 1970 example shown below was quicker-hitting, with selling hitting the market soon after the signal in May, followed by a rally and another dip, before kicking into a huge bull run.

“Mike, this all sounds pretty iffy—I thought you said these signals were bullish?”

They are! The good news is that, historically, (a) the prior lows always held, (b) the worst of any pullback was finished within a couple of months from the signal, and (c) the 6- to-12-month returns were right up there with all the other signals.

Don’t misunderstand us: This isn’t our way of excusing the market’s latest action or saying that a 5%-plus dip from here would be no big deal. To the contrary, we’ve peeled back a couple of recent buys and have more out of the market than invested at this point. Plus, of course, the Four Day Frenzy is just one indicator, so we’re not going to ignore the other evidence.

However, history tells us that the current retreat could go further, but also isn’t out of character with a market that’s already bottomed (or is in the process of doing so). We’ll see how it plays out, but it’s something to keep in mind amidst the barrage of bad news.

Keep an Eye on Defensive Stocks
One of our favorite tea leaves to read early in a new advance (as well as after an advance has gone on for a while) is the action of defensive stocks, especially in comparison with growth stocks. That’s really the basis for our Aggression Index, which is simply a relative performance (RP) line of the Nasdaq vs. the consumer staples fund (XLP). The theory surrounding it is simple: When toilet paper, soda and toothpaste are outperforming chips, software and cybersecurity, it’s a good bet big investors aren’t exactly in a risk-on mood, preferring safety over potential upside.

Recently, our Aggression Index had a brief rally above its 10-week line, but that bout of strength has been erased, with the RP line diving back toward its lows.
And, interestingly, when we broaden our view to other defensive areas, the picture is actually worse. Shown here are also the RP lines comparing the Nasdaq to the Utilities (XLU) and Health Care (XLV). (Yes, XLV has a bit of growth to it, but the biggest components of the fund are massive, cheap, dividend-paying pharma outfits—not fast-growing medical device or biotech names.) As you can see, the RP lines of both look even worse compared to the XLP, as they never overtook their 10-week lines, with both currently setting new lows!

We think this is descriptive and not necessarily predictive, but there’s no question that big investors aren’t exactly eager to commit to growth stocks, especially those that have shown solid relative strength in recent weeks. Going forward, we do think the action in defensive stocks (especially in relation to the Nasdaq or growth stocks) is worth watching: Simply put, we’ll be looking for a change in character in these measures as a sign that institutional money is taking a more risk-on stance. So far, we haven’t seen much of it.

Cabot Market Timing Indicators

The sellers have shown up again in recent days, with supply hitting many areas of the market after the encouraging March run. Our Cabot Tides haven’t reversed their signal yet, so we’re not completely returning to our storm shelter, but with few growth stocks really kicking into gear on the upside, we’ve pared back a bit and are still holding lots of cash.

Cabot Trend Lines: Bearish
Our Cabot Trend Lines remain negative, though there’s been improvement—the S&P 500 is standing a bit more than 1% below its 35-week line, but the Nasdaq is still 6% or so under water. We need to see both indexes close two straight weeks above their respective trend lines to get a fresh buy signal—we’re all for it, of course, but until it happens, the longer-term trend is down (sideways at best), which is a headwind for the market.

Cabot Tides: On the Fence
Our Cabot Tides turned bullish last week, but the sharp decline of late has already put that signal on the fence. Right now, broader measures (like the S&P 600 SmallCap, shown here) have cracked, though bigger-cap measures are holding up better. Much more weakness (especially in the Nasdaq) could put the fork into the nascent uptrend, but we never anticipate these things; the buy signal is intact, but the next few days should be telling.

Cabot Real Money Index: Neutral
Was there enough pessimism to “re-set” the big-picture market advance, or do we need another few weeks of shaking and baking to set the stage for a huge advance? That’s the question of the day, and the Real Money Index makes you wonder if the latter is the case—investors never really bailed on stocks despite the horrid action, and now money is pouring back into equities. It’s a secondary measure, but we’d prefer to see more worry when it comes to real money flows.

Charts courtesy of StockCharts.com

The next Cabot Growth Investor issue will be published on April 21, 2022.