RSS feedWe discussed pullbacks from a technical perspective last Friday. As you may have been able to tell from the chart example, it can be a little bit difficult to play interim pullbacks during an uptrend. Even harder if you’re trying to catch pullbacks during a rapid rally. In fact, 50% of the gain in Coach’s stock from July 2006 to July 2007 occurred without any significant “pullback.” It is possible, however, to find pullbacks in longer time scales. Often times, market prognosticators and quasi-traders like Jim Cramer will call these situations “corrections” and warn against purchasing the stock. Intermediate to longterm pullbacks and periods of stagnancy are not necessarily corrections, however.
Sometimes, intermediate term pullbacks can be a terrific buying opportunity. It, however, requires a more fundamental understanding of the company behind the underlying stock and a longer time frame than a few days or a few weeks. In fact, proper fundamental pullbacks require at least a quarter (3 months) or more to materialize.
Here, we look at Apple’s stock between 2004 and 2007. Over this period, Apple blew away earnings estimates and released a succession of hit products while also having continuous explosive growth from its iPod product line. What we see is that the stock responded growing from 20 to 120 in jut two years. It was not a march straight north-east, however, as shown by the double bars, there were periods in which Apple’s stock was essentially dormant for months at a time.
Most stocks headed northwards exhibit very similar movement. Rarely, will you find a stock that over a period of a year will not find a few months of lateral movement and maybe even lose 10-15% of its value in that period as well. Why does this happen? A plethora of events both within the company and in the macroeconomic environment can act as a damper on a stock’s rocket rise. Anytime you’re invested in a stock a time horizon demarcated in years, you can expect these periods. They represent the market catching its breath after screaming and yelling and getting overly exuberant about a stock.
All stocks, particularly growthy stocks, will experience intense rallies as the public grabs onto the story and begins to buy into the company’s longterm prospects. Eventually, the valuation of the stock will overshoot true value and savvy investors will begin to take profits. Sometimes, analyst expectations will get so high that even the best company can’t keep up and this too will trigger additional selling pressure. “Greater fools” who bought in at the end of the rally will have their confidence shaken and follow suit in the selling. With the market’s confidence in the stock shaken, the stock will move laterally as participants wait for new information and figure out where to go next.
The basic principles of these pullbacks is the same as that of a day-to-day pullback. While the uptrend may break, the stock should find buying support at some discrete level - this often termed a base. Think of bases as price levels. A stock who’s fundamental prospects are positive and who’s earnings grow consistently should will exhibit new bases whose lows will be materially higher than the highs of a previous base. Falling from a new base into an old price level should signal to you that something is very wrong with your analysis of the company and stock that you’re following as the market has reversed course on its opinion of the stock.
During these bases, stock’s who have overshot their value will pullback a little and find that their P/Es contract as the demand for the stock cools. Provided that fundamentals remain strong and the company continues to perform, these are periods where you can often find value in a hot growth stock as it prepares to ascend to new heights. For some examples of how pullbacks often manifest themselves in charts, check out this tutorial on chart patterns provided by Investors.com.
The key here, though, is to remember that these chart patterns are not magically predictive of the future. Sometimes, stocks will base as they’ve hit the limit of their upward potential. Whether it be unrealistic market expectations or maturing business, the growth potential of the company behind the stock will falter and bases can fall out and turn into full on corrections. To me, a correction happens when the bottom falls out of a stock’s valuation. A good example might be that of Starbuck’s over the last two years. Here, the stock reached a valuation of 30 times earnings as its business matured and reasonable expectations for growth were no longer supportive of such a P/E. What we found was that the market soon corrected its valuation and the stock has tumbled to more reasonable valuation levels at $19/share. Possibly good for those looking for value, but bad for those who bought into the Starbuck’s hype two years ago.
