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 That old saying "the trend is your friend," can, not only be helpful, but also be a warning, at times, if you know your way around the stock market.
I spoke with one investor recently who told me he was starting to short the home building stocks. They have been the hottest group since 2000. When the general stock market went into one of the worst bear markets of the past 100 years, home building plays were the place to be. They did well because of lower interest rates and strong demand for houses. Stocks such as Standard Pacific Corp. (SPF) soared from $10 in 2000 to $85, Lennar (LEN) from $8 to $63, Toll Brothers (TOL) from $10 to $98 and Hovnanian Enterprises (HOV) from $5 to $63. Others did fabulously well.
Earlier this year, home building issues started to pull back. Common sense might lead one to think their time was done and they were due for a significant decline. Thus, this particular investor shorted some of them.
However, he was badly mistaken. He fell into a trap.
Even though many home building stocks pulled back some 12% to 25% during March through April, afterwards, they turned and rallied strongly making new highs. For example, Standard Pacific pulled back from $82 to $65 but then rallied. It is now $85. Lennar retraced from $62 to $52. Then, it got back to $61. Toll slipped back from $92 to $73. However, it rallied powerfully and is now $98.
For eSignal subscribers, the lesson is this: You want to be careful about being a big bad bear in a bull market and especially trying to short a strong group.
It is true that top fund manager Ken Heebner, who runs the CGM funds and who was a big winner with housing-related stocks, recently said he was moving away from them. He expressed concern about increased speculation in the group. But, selling and moving away is a lot different from trying to short.
Generally, the time to short a top-performing group is on the second decline off a potential peak, not the first. On a chart that would show up as the classic head-and-shoulders technical pattern, and then the breakdown from the "shoulder."
Two other important tips
First, you must always determine whether the stock market in general is in a bull market or bear market. That can be discovered by looking at two key items.
The first is to know the general technical pattern of the major averages, such as the Dow Jones industrials, Standard & Poor's 500 index and NASDAQ Composite index. The way to do that is to identify the basic trend of those indices by looking at a chart. Simply said: Is it up or down?
Pull up a weekly chart of the indices with eSignal's advanced charts and then draw a trend line by connecting the lows and another by connecting the highs. If you were to do that, you would easily see in retrospect that the current bull market began in March of 2003 and is still in force. The trend is up.
The second check is to consider the business cycle. Are corporate profits improving? Yes. Are interest rates moving up? Yes. Are businesses expanding operations and are the economic indicators showing growth? Yes. That confirms the bull market.
Knowing what kind of market you are in bull or bear, will determine your bias. In a bull market, you want to look to go long. In a bear market, you want to go short, or, if you are conservative, hold cash.
The indications now are that stocks are still in a bull market.
Another important thing to realize is that there will be what is called "industry rotation" as far as stock price action goes. Money will flow into a particular industry group, say HMOs, and drive many of those stocks higher. Then, they will rest or drift back, and a different group will come to life as money moves into that area.
Generally, in a bull market, several sectors are the leaders. The stocks in those groups go up and then rest. After a certain period of time, the group comes back to life and advances again. What is the underlying cause of that? In most cases, it is general corporate profitability.
The name of the game is money, and companies whose profits are rising sharply will see their stocks bid higher. Another interesting phenomenon of a bull market is that some of the leading stocks with powerful earnings will see their stock prices bid extremely high, well beyond reasonable valuations. So, one trick is to keep some money in them because they could turn out to be a "jackpot stock."
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