I've been rooting for a year-end rally as long and as hard as any investor out there. After all, I added
to Jubak's Picks in late August,
in early September and
in late October in hopes of such a rally. And if the market doesn't deliver a pretty sizeable bounce -- and I mean sizeable -- now that the presidential election finally seems to be coming to a close, I'm looking at red ink in all three of these positions well into 2001.
So I was cheering as loudly as anyone when, on Tuesday, the
Nasdaq Composite soared 274 points and the
Dow Jones Industrial Average climbed 338 points, gains of 10.5% and 3.2% respectively. If events break right -- true closure in the election, a clear indication from the
on Dec. 19 that it's standing down from its inflation watch -- this rally could even have legs.
But while I certainly enjoyed Tuesday's rally, I am also trying hard not to let my euphoria run wild. Technology stocks have suffered major damage this year, and any recovery will be slow and halting, I've been reminding myself. Stocks that went through major support prices like a knife through butter will now have to work their way back up in the face of selling at each of these price points. And no rally is going to reverse the very real slowdown in earnings growth that is plaguing technology sectors from telecommunications chips to PCs, or the more general deceleration in U.S. economic growth as a whole. With
and others with warnings about lower-than-expected fourth-quarter earnings, it's clearly no time to get complacent.
Not Out of the Woods
At this point in what is now a nearly nine-month technology bear market, I think it's important to realize that we can have a major rally in the
that still does not put an end to the downtrend in the prices of technology stocks. I think the Nasdaq could rally to 3500 or even 3700, but it would still be vulnerable to returning to 2600 if we get bad earnings news, either in the form of December warnings or January disappointments. I don't think we're going to be out of the woods with this market until it's clear that the inventory corrections now going on in the semiconductor and the telecommunications-equipment sectors are over, and until we see an uptick in quarter-to-quarter earnings growth. And right now that doesn't look likely until the March, or maybe even June, quarter.
That doesn't mean there isn't good money to be made during a bear-market rally. In fact, that's my dilemma. Staying on the sidelines until the bear retreats to its cave is definitely the safest strategy. But it means passing up any profits to be made during a strong, if temporary, year-end rally.
Individual stocks can make huge upward moves within that long-term downtrend.
, for example, rallied almost $27 a share on Dec. 5 to $127 a share, and it doesn't face major resistance above this level until $160. A move to $160 would still leave the stock in a downtrend that now stretches back to Sept. 1, when it traded for $250 a share. But an investor who bought at recent lows near $92 would be looking at a profit of 74% if the stock hits $160. Even an investor who bought near $130 after the Dec. 5 run would pocket 23% if the stock hits $160.
So what should you do? I think there are three major choices:
You can stay in cash on the sidelines -- if you're already in cash. That's certainly the low-risk stance. You don't run the chance of losing a dollar if any rally peters out well short of Nasdaq 3500. You won't make a cent from any short-term rally, but you will preserve your capital for a buying opportunity down the road, when it's much easier to see that the market has truly turned.
If you already own some very crushed technology stocks that you no longer want to hold for sound fundamental or technical reasons, you can sell into a short-term rally as quickly as you can, figuring to get out before the bear returns. In other words, take the gift and run. Like the first strategy, this one will reduce your risk of further losses. But it certainly limits your chance to profit further if a rally turns out to be more than a two- or three-day wonder. In fact, if the rally continues, you're likely to wind up kicking yourself over the money you left on the table. I don't especially like strategies that show a high probability of ending in self-abuse. In my experience, investors smarting because they sold too early have a tendency to try to fix the mistake by buying back into the market at much higher prices -- often exactly when they should be exiting.
Last, you can attempt to understand the risk and reward of individual stocks so that you can buy or hold while the "easy" money is on the table, and then sell when the likelihood of a profit-eating reversal looms. This strategy is obviously riskier, but it also offers the potential for higher reward. Applied skillfully, it should prevent an investor from chasing a stock once it has climbed into the "danger" zone. By taking some profits, too, it builds up cash that this investor can use in future buying opportunities. And it does have one other argument in its favor: If I'm wrong (always a possibility that I urge you to consider) and the bear is finally in full retreat, an investor who follows this strategy will be invested in the market as it recovers, rather than watching from the sidelines.
I can't give you the parameters to execute that third strategy with every stock that might be on your watch list. But I do know why "easy" money exists in this kind of a market, and I can share some basic tools that I use to set such limits for my individual stocks.
Going After 'Easy' Money
"Easy" money exists because in a collapsing market like the one we've had for the last few weeks, stocks fall quickly and relentlessly as fear feeds on fear. Stocks that are plummeting don't spend time building intermediate bases on the way down. They're simply falling too fast. Investors don't care what price they get when they sell -- they simply want out. Many stocks become hugely oversold, and once these stocks start to recover, the absence of those "intermediate bases" on the way down translates into fewer "resistance levels" on the way back up.
(The theory is that those intermediate bases represent purchases by lots of investors at specific price levels. Those investors lose faith in their purchase as the stock continues to fall, and when it finally turns around, they are so skittish that they're happy to sell when the stock gets close to the price they originally paid for it. As all those investors bail out, happy just to recoup their original investment, it puts at least a temporary lid -- or resistance -- on the stock's upward price movement.)
, for example, fell from $138 on Nov. 3 to $58, with only a brief pause at $72. Now I don't see major resistance for the stock until it recovers to the $108-$114 level that it last visited in early October.
Or how about Extreme Networks? The stock has clearly established a downward trend since it hit $124 on Oct. 16. Each high since then has failed to reach the one before it, and each low has also been lower -- substantially lower. The Nov. 30 low near $51 was a solid 25% below the Oct. 25 low near $68. But the speed of the last leg of that descent -- from $80 to $51 in a week -- has meant that it hasn't been too hard for Extreme to make up that ground. It doesn't face major resistance on the way back up until it nears $80. If the stock gets through that level, however, it faces a real struggle at $86, the current level of the 50-day moving average.
is an even clearer example. On Dec. 5, the stock moved back above its 200-day moving average and the next day, damaged by the news that
was selling about half its stake in the company (10 million shares), it fell just below that level. The next major resistance level, assuming that Juniper gets through the 200-day average, is the 50-day moving average at $180. After that, the going gets much tougher, with major resistance at $200, just $20 a share, or about 11%, higher.
Those of you who have climbed even a modest mountain or looked at a topographic map will recognize the pattern that Juniper's stock price has traced. At the bottom of the slope, the resistance levels in the stock chart -- like the elevation lines on a map -- are relatively far apart. Climbing from one to the next doesn't require too much energy. But as the stock or the climber gets nearer to the top, the resistance and elevation lines get closer together. Continuing to climb requires more and more exertion. Weaker climbers -- and weaker stocks -- have to rest more frequently; some don't make it up to the top at all.
What's the Risk/Reward Ratio?
I think investors should use these patterns to gauge the potential risk and reward in a technology stock. As a PMC-Sierra, or a Juniper, or an Extreme Networks climbs toward major resistance, the risk in the stock increases and the potential reward decreases. Buying Extreme Networks at $60 in a market rally means pretty good odds that the stock will make $80 -- a 33% potential profit. Buying at $80, however, the odds aren't nearly as strong in your favor, because the stock stands a good chance of topping out at a prior high. Of course, the potential reward isn't nearly as great, either. Even if Extreme Networks manages to hit $86, the 50-day moving average, it would only be a 7.5% gain for the investor who bought at $80. If you believe we're still locked into a bear market for technology stocks, as I do, then any stock that rallies near to major resistance certainly becomes a potential sell. That's why I'm selling Extreme Networks out of Jubak's Picks with this column. Sure, the stock can continue to rally from here, but I don't think the risk/reward ratio justifies betting on that possibility.
Even in this market, however, a stock that is approaching major resistance isn't always a sell. As useful as charts and technical patterns are, they are backward-looking indicators. They don't capture changes in future fundamental conditions.
No chart is a guarantee that a stock will match past peaks if company fundamentals are weakening.
, for example, doesn't seem to face major resistance until $49 -- a very tempting potential 25% gain from recent prices. And after that level, the next stop would be $62.
But I sure wouldn't count on the stock to bounce up to those levels, because the near-term fundamentals at the company are still showing signs of decay. Nortel has recently decided to triple its lending to European customers so they can buy its equipment. Making $3.7 billion in potential loans available to customers is certainly one way to keep sales growing at Nortel, but the move doesn't fill me with confidence about growth in the company's market. At the least, I'm sure analysts will raise the increasing loan commitments as a red flag when the company reports in January. At the worst, Nortel could get stuck holding the bag if one of its less-creditworthy customers blows up. No matter what the chart says about resistance levels, Nortel has just become too risky for me. I'm selling it out of Jubak's Picks with this column. (Long-term investors in Nortel should consider cutting back to a core position in the stock. That's what I will be doing in my own portfolio three days after this column runs.)
You'll notice that I've now cleverly slipped fundamentals into a column that began with nothing but technical analysis. I know that's likely to rile the true believers in either of these methods, but I'm a firm believer in using any and all tools that can help.
And so, next column I'm going to tackle this same risk/reward problem from a fundamental approach, by looking at how investors can determine the value of a technology stock at the bottom of a cycle in its sector.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Ariba, Extreme Networks, GlobeSpan, Intel, Nokia, Nortel, Nvidia and PMC-Sierra.
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