My favorite insect is the banded wooly bear caterpillar, a.k.a. Isabella tiger moth, a.k.a. Pyrrharctia Isabella.
In the larvae stage this thirteen-segment creature is covered with brown hair in the middle, and black hair at the extremes.
They’re undeniably cute, always look cozy, have no gross appendages poking out anywhere, and it’s impossible not to smile when you see one.
The wooly bear doesn’t bite, it isn’t poisonous, and it won’t cause a rash.
It’s also not very fleet of foot, which makes it exceptionally easy to catch. The insect’s defensive stance – they just curl up into a ball and lie still when disturbed – makes them easy to pick up and pass around with the kids.
The wooly bear is also an incredible evolutionary specimen. It has adapted to survive temperatures down to -76° F. They accomplish this by producing cryoprotectants, an anti-freeze like substance that protects the caterpillar’s organs and brain from freezing solid when harsh conditions arrive. This is one of the reasons the wooly bear has the longest life span among its peers, living up to 14 years.
Perhaps the wooly bear’s most attractive attribute is its ability to predict the future. Legend has it that the more brown segments a wooly bear caterpillar has, the milder the upcoming winter will be. Fewer brown segments (i.e. more black ones) means a more severe winter.
I think that investors – who are somewhat obsessed with looking for reliable indicators to predict the future – can appreciate that this seemingly simple creature is trying to tell us something!
Is the wooly bear reliable?
In 1948 Dr. C. H. Curran, the curator of insects at the American Museum of Natural History in New York City, began an eight-year span collecting and analyzing caterpillars in an effort to prove the insect’s predictive abilities.
He found a trend and concluded there might just be some merit to the legend.
I wouldn’t recommend buying your clothes based off the number of brown segments on all the wooly bears you spot. Fortunately, market data is more readily available than caterpillar data. And I have some to share that appears relatively robust in terms of predicting what’s going to happen over the next three quarters.
It regards the stock market’s quarterly returns throughout a presidential cycle, and most notably, following midterm elections such as the one we just had.
The data is summarized in the chart below from LPL Financial, who collected data from 1950 through 2017. The punchline is that in the fourth quarter of a president’s second year (i.e. the current quarter) the average return of the S&P 500 was 7.8%. Roughly 90% of the time, the return was positive.
The data also shows that in the following two quarters the broad market delivered positive returns well over 90% of the time in Q1 of year three and roughly 70% of the time in Q2 of year three.
In other words, history suggests that the stock market will go up now, for three quarters in a row.
LPL Financial had a second compelling chart if you’re leaning bullish (and scary if you’re short the market). Since 1950, the S&P 500 has delivered a positive return after reaching an October low through year end 100% of the time in years when there were midterm elections.
The average return of 10.7%, with a 100% “win” ratio over a sample size of 17 years, is the most compelling evidence I’ve seen yet for a market rally through the end of the year.
Let’s say the market does rally. What does that mean for small caps?
It should mean good things. First, the S&P 600’s October closing low of about 920 was less than 4% below where the index is now. That means if the patterns I just mentioned play out there could easily be more upside. Perhaps more importantly, downside should be very limited.
Second, analysts are currently projecting S&P 600 Small Cap earnings to grow by 14.3% in both 2019 and 2020. Comparatively, the expected EPS growth rate for the S&P 500 Index is 8.3% in 2019 and 10.5% in 2020.
The small cap index is trading with a forward P/E of 15.9, while large caps trade with a 15.6 multiple.
Both indices are up around 2.5% year-to-date.
Put together this all means small caps are expected to grow EPS faster, trade at only the slightest valuation premium AND are neck and neck through the first 11 months of 2018 with large caps.
That sets up a compelling relative performance argument in favor of small stocks in what is usually a strong period for stocks. I expect we’ll start to see some of the big investment banks overweight small caps.
In terms of what to do this second, we’ve just received a modest buy signal for small caps as the S&P 600 jumped above its 25-day line on Wednesday (and held above it yesterday).
This isn’t a screaming buy signal. But when combined with similar evidence of short-term strength in other indices (and emerging markets) it appears that appetite for stocks, including the “riskier” ones, is returning.
We’ve maintained as much exposure to our stocks as I’ve felt comfortable with through the downturn. With some of the big-picture concerns beginning to dissipate (interest rate hike schedule, trade, etc.) and stocks looking better we’re going to move slightly more aggressive today to try and catch an updraft.
This isn’t to say you should throw on your rally cap and load up on stocks. Caution is still warranted. But it’s time to start thawing out, reduce the amount of cryoprotectants pumping through our veins, and look to step into some rays of light emerging from the market.
Changes this week
Everbridge (EVBG) Moved to Buy
Goosehead Insurance (GSHD) Moved to Buy
Rapid7 (RPD) Moved to Buy
One quick housekeeping note: If I have a stock rated at “hold a half”, “hold a quarter”, “sell a quarter”, etc., that means hold/sell/etc. that portion of your initial position in terms of share count. In other words, if you bought a full position of 1,000 shares, and I recommended selling half (500 shares) then selling a quarter (250 shares), you would have 250 shares left.
Updates
Altair Engineering (ALTR) has been a troubled stock almost from the moment I added it to the portfolio in early October. Despite my best effort to find a resilient software stock in a market where most had run pretty far, it’s now clear that the precise timing was about as bad as possible. Had I not recommended it then I’d be watching very closely now for the stock to regain the 33 level, stay stable, then start to gain altitude again in the context of at least a modest software stock rally. If that were to happen (and I had never recommended it) I would likely have pulled the trigger to add it to our portfolio. The same reasoning applies now. For the time being, Altair is a hold. If something close to the aforementioned scenario plays out, it will become a buy. I believe this is a quality company and the fundamentals are attractive. We just need better price action. HOLD.
AppFolio (APPF) jumped above its 200-day line on Wednesday and is now at its highest level since mid-October. That’s not enough to upgrade to buy but it’s a decent indication that continuing to hold on to the stock, which sells cloud-based software for business in the property management and legal industries, is the right call. HOLD.
Apptio (APTI) announced a deal earlier in the month to be taken private by Vista Equity Partners at 38 a share ($1.94 billion). We booked a gain of 69% over a holding period of 11 months. There’s no new info to share. SOLD.
Arena Pharmaceuticals (ARNA) has made a nice move in November after announcing it would out-license its ralinepag asset to United Therapeutics (UTHR) for up to $1.2 billion. Ralinepag is being investigated for the treatment of pulmonary arterial hypertension (PAH), and this announcement drove the stock up over 20% the day after it was announced. United is in the PAH market with a (likely) inferior asset (Orenitram) so should be able to do good things with ralinepag and drive a nice royalty stream (assuming eventual approval). The deal means an $800 million upfront payment, a $400 milestone payment, and tiered low double-digit royalties on global sales. The capital will help Arena move etrasimod and olorinab (as well as other early-stage assets) through the pipeline. Shares are up 4% over the past two weeks. Keeping at buy. BUY.
AxoGen (AXGN) is back to where it was prior to last Monday’s stock market rout. It’s likely going to take a little while for confidence in the name to return so just hold on to what you’ve got and we’ll look for signs of a more significant uptrend before moving back in. A good sign would be a move above the 37.5 area. AxoGen sells nerve repair solutions. HOLD.
Bottomline Technologies (EPAY) looks oversold to me and hasn’t fallen any more after the big one-day decline that followed earnings. I’ve kept at buy and am sticking with that rating today. Its biggest business is providing a cloud-based payment network for businesses and I think that’s going to prove to be a very lucrative area for investors to be in the coming years. BUY.
Chefs’ Warehouse (CHEF) was one of the stocks I flagged as a hidden gem at the Cabot Wealth Summit in September and it’s demonstrated why lately. Like many stocks it went through a concerning drop in October, but the pain was essentially confined to three sessions. Since October 15 the stock has been climbing back. Yesterday it closed at a 52-week high! We’re up 26% since I added Chefs’ in July, and shares are up 15% over the past four weeks. It’s not a screaming buy here but if we get a few down days it’s OK to pick up a few shares. The company distributes specialty food to independent restaurants and has been investing in its distribution network and technology platform, both of which should drive faster earnings growth in the coming quarters. BUY.
Everbridge (EVBG) has earned its reputation as one of the most attractive small-cap SaaS stocks out there by holding up relatively well through October then bouncing right back from last Monday’s tech stock crash. Shares are now back above their 50-day moving average line and a few first downs from their 52-week high (18% above where they are now). I like the action and am moving back to buy. Just keep new positions small. BUY.
Goosehead Insurance (GSHD) is another stock that’s looking a heck of a lot better this week. It has moved back into what I’d consider a comfortable trading range above the 24 to 26 area that had provided support before the meltdown earlier this month. Granted, it’s not flying high just yet. But the swiftness of the recovery from a dip to 20.49 is encouraging. We’ve oscillated between having a quick gain on this stock to having a quick loss, but I haven’t lost faith. It’s hands-down the fastest growing company in the insurance industry (estimated 2019 revenue and EPS growth of 40% and 68%, respectively) and is still flying well under the radar. We have a little more room to play with here so moving back to buy. BUY.
IntriCon (IIN) is still looking rather beaten down. We reduced our position to make sure we locked in at least some profit and IntriCon will need to show convincing strength before I’ll move back to buy. For now, keep holding the medical device manufacturer. HOLD.
Q2 Holdings (QTWO) has linked together six consecutive days of positive gains and closed just a hair below a six-week high yesterday. It’s up 3% over the past four weeks. The digital banking software stock looks like it has reasonably strong support around this level. If you never established a position but have wanted to, you can nibble on a few shares around here. Otherwise keep holding. HOLD.
Rapid7 (RPD) is our security stock and it was holding up well before the tech stock crash last Monday. That selloff drove shares back to their July low, but they’ve clawed their way back to a more comfortable buy range. I might be a little early but Rapid7 is moving back to buy. BUY.
Repligen (RGEN) still looks fantastic and the modest retreat last week looks entirely normal in my view. Repligen designs and sells bioprocessing technologies that make it more efficient to manufacture biologic drugs. This is a booming market and demand for Repligen’s products, and stock, appears to be high. Keeping at buy. BUY A HALF.
Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.
