Former Tech Leaders Emerging Again

08/20/2012 8:45 am EST

Focus: STOCKS

Edward Hornstein

Founder and Managing Partner, Hornstein Capital Management, LP

Asset manager Edward Hornstein goes over the chart action in several techs that seem to be showing signs of life again. He also talks about a recent IPO from the retail sector where he sees strong potential ahead.

Kate Stalter: Today, I'm speaking with one of my favorite guests here on The Daily Guru, Edward Hornstein of Hornstein Capital Management.

Ed, we've been in a confirmed rally here for the past few weeks. I think it took a lot of traders and investors by surprise. Tell us what you're seeing out there, in light of the recent market action.

Edward Hornstein: Well, the market bottomed at the end of May and early June, after going through a pretty quick and vicious 10% to 12% correction, depending on the indices.

I think the ultimate bottom, at least looking at the Nasdaq, was on June 4, which uncoincidentally was right around the longer term 200 day moving average. Since June 4, the indices-I'm looking at the Nasdaq just as a proxy-they've gradually worked their way higher.

It's been very choppy, just indices-wise. It's been three steps forward, two steps back, three steps forward, and two steps back. It's kind of been choppy. Right when it looks like the market is going to break out, it pulls back, and right when the market looks like it's going to break down, it kind of goes up again.

So it's basically just been a stairstep up for most of the past two months, let's say. We've had one or two follow-through days. We had one at the end of June. We had one at the end of July.

But the one thing really absent from this rally, up until recently at least, was the liquid leadership in the market. What we look for, most powerful rallies have a set of leaders. They're usually pretty liquid.

The proxy I use is over $100 million a day. So if you have a $100 stock you generally want to see at least a million shares trading hands a day. A $50 stock at 2 million shares. That's kind of the proxy I use.

You want to see those stocks breaking out of sound bases into new high ground. Even though the market has been going up, there have been maybe one or two stocks that have that sufficient liquidity, a stock like Mellanox (MLNX), which is a chip stock.

But most of the strength of the rally-up until I'd say the past week or two weeks-has been a lot of stuff off the bottom that got really beaten up; whether it was commodity stocks, anything metals, mining, aluminum, the oil stocks, some of the financials and some of the other growth leaders that have kind of rounded out and come up.

Over the past week or two, though, I'd say there's been a gradual improvement in the leadership of the market out there. We've had a few more stocks, which we can discuss, that gapped up out of bases on earnings and are holding their gains. Recently we've had a few other of the liquid "glamour stocks" either break out into new high ground, or kind of tighten up and are attempting to break out right now.

That missing piece from this rally, which is powerful leadership, is kind of starting to come on right now. So we have the potential to be in a transition phase here, where if this rally is going to work over the next few weeks, you would expect to see a lot of these leading stocks start to substantially outperform the market indices.

The example I use-we can just go back into recent memory until last year. The market bottomed in October 2011. We had a follow-through day around December 20, about ten weeks off the lows, but the real liquid leadership didn't start breaking out until the end of January. That's when Apple (AAPL) and Priceline (PCLN) and Intuitive Surgical (ISRG) and Kors (KORS) and some of these other stocks like Rackspace (RAX) really started to take off. That was about two-and-a-half to three months off the lows, and about five or six weeks removed from the follow-through day.

If we just look now, the correction wasn't as substantial as last summer. We bottomed around early June, and right now we're about ten weeks from that bottom and about three weeks from the last successful follow-through day. So it's not unprecedented to see a market rally for a substantial period of time off their lows, and then later in the rally to see the growth stocks start to take on the form of leadership. That's something that should be watched very closely, and we can go through those stocks.

Does this transition continue, where over the next few weeks we see the growth liquid leaders really start to lead and outperform the market? If that happens, that's going to be a really good sign for the rally. Or we see more of the same, where you don't have that leadership and it kind of peters out. If that happens, obviously, that'd be a negative for the rally.

At least at this time, given that we're on a follow-through day and you're starting to see some of these leaders transition into a proper leadership role, I think the market should certainly get the benefit of the doubt at this point.

Kate Stalter: I like that term, the "liquid glamours." Apple, of course, probably being the first one that comes to mind right now. After getting beat up on its earnings report, it has rallied right back up to some new highs again. Tell us what you're seeing in that stock, and maybe some of these other more liquid growth names that you tend to follow.

Edward Hornstein: Apple is a little bit more of a late-stage base. It's been around for a while. It's had a big run. It's been basing out.

But if there's one stock that can probably continue, even though it's a little long in the tooth, that would Apple, just given that they're still accelerating their numbers. Even though they didn't last quarter, they've got some new products in the pipeline, which I guess the Street is thinking is going to help them accelerate their top and bottom lines again.

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The volume has a little bit iffy, coming up the right side of its base. But historically, that sometimes happens with Apple. The prior high was $644. The stock is right at $636 right now, so it's getting very, very close.

If this thing can get into new high ground, then you've had a traditional O'Neil buy point on a handle from about $620, and it's holding that point. You really want to see Apple get above $644 on volume and start to power its way up to $700. If that happens, that would definitely correlate with a nice rally in growth stocks.

Another growth liquid leader that's long been forgotten is Google (GOOG). It's funny that we talk about Apple and Google, because back in 2004 and 2005, the market was kind of choppy like it was now, and it was pretty much just, "Own Apple and Google and forget about everything else," and you made a lot of money.

Apple has continued since then, and Google has kind of, over the past few years, every time it tries to get going, it gets smacked. The interesting thing about Google is, it formed a long double bottom and it recently broke out.

If I'm looking at a chart of Google right now on a daily, you could see it's pretty much straight up off the lows from about $560. It hasn't really paused, but that's what a double bottom should do. A typical cup base is more rounded. It takes its time, it forms a handle, it's nice and smooth.

The double bottoms that work, they bottom a second time like a W, and it looks like a W. There's a straight line up. That's exactly what Google is doing. If you look at a daily or weekly, you can see that there's been significant accumulation in the stock since the earnings report back in late July.

The other thing is today is Thursday, but tomorrow would be Friday. You've got a chance of, if it closes well for five weeks up in a row on a stock-I remember meeting Bill O'Neil once, and he told me one of the signs he looks for in a stock to measure strength is, five weeks or more up in row on volume, all closing at the top of the range, which Google is doing.

So I'd say Apple and Google are definitely two stocks that are trying to assert leadership here.

Amazon (AMZN) is another one. The stock formed about a year-long cup and handle, and it's now trying to break out into new all-time high ground. Its a few points away as of today. That's got sufficient liquidity.

We saw Michael Kors (KORS). This was a really hot IPO. The stock went from about $25 to $50 very quickly, and it's been in this long wide and loose choppy base here. It recently, a few days ago, gapped up into the top of the base on a really good earnings report. The stock is now just kind of sitting around.

This is a very liquid stock. It's got the right fundamentals; it's about a dollar away from its all-time high. This is another one that could provide leadership as well.

Mellanox (MLNX) I talked about earlier. This was one of the first stocks to come out. It kind of gapped up from a base and it pulled back to its 50-day moving average at the end of July. It's basically just kept going up. It's been sitting around for a few days now in very light volume; it's extended from when it gapped up.

It's certainly a hold. I don't know if I'd be buying it here, just because it doesn't really have a proper buy point at this point, but that's definitely a stock that's providing leadership.

There's a few others that are kind of rebuilding. Baidu (BIDU), which was obviously a big leader back in 2009 and 2010. It basically sat around for a year-and-a-half, and this one is trying to come up the right side of a base. It's got improved accumulation. It still needs a little bit of work, but it's definitely been showing at least some early leadership qualities here.

I'd say some of the cloud stocks as well, like Salesforce (CRM). The interesting thing which I noticed about this stock is, it's forming another base here. If you look at a daily chart, you'll see that unlike prior corrections last year, on the correction this time the 50-day moving average held above the 200-day moving average, which is always a good sign.

The stock has had a lot of support at the $120, $125 area, and it's coming up very quickly. It's got really good volume. It's trying to rebuild. I think they report in about a week, so that should be interesting.

Then there are some other stock as well that are liquid. EBay (EBAY), which is liquid is definitely looking like a leader, Under Armour (UA), Gap Stores (GPS), which is kind of a turnaround play, Equinix (EQIX) is certainly trying to exert leadership, and some of the disk-drive stocks like Seagate (STX) and Western Digital (WDC).

You've got some biotech stocks that are strong. You've got the housing stocks, which are very strong, and a lot of the ag and fertilizer stocks. There's definitely enough there now in terms of liquid leadership, that if the market starts to rally, you'd expect some of these areas and some of these names to really start to outperform. That's the key to look for on the stocks that I discussed and some others: See if they're breaking out, continuing to outperform the market indices, should the rally continue.

Kate Stalter: Just to wrap up today: You've given us a lot of great ideas and a lot of the technical aspects to watch for on the charts. When it comes to the fundamentals, that's how a lot of investors are accustomed to analyzing stocks. What do you look for in that regard, in addition to the technicals you see on a chart?

Edward Hornstein: The two most important things that I look at are-and this is not rocket science to anyone that follows the CAN SLIM or a corollary of the O'Neil approach-accelerating earnings and sales. How I kind of explain it is: Mutual-fund/hedge-fund managers, especially the growth managers, they are very interested in stocks that have real top-line and bottom-line growth.

The idea being, that if you're a growth fund manager and there's a stock like Apple that's just got these innovative products that are growing faster than anybody else, even if you don't want to own the stock you're almost forced to. Because at the end of the quarter when you have to report, if you don't show that you own Apple, everybody on the committee and your investors are going to start asking why.

The whole idea here is to find those stocks with those gigantic fundamentals that the institutions are almost going to be forced to own. You basically want to look at companies that have accelerating earnings and sales growth. It's not necessarily enough to see 30% or 35% earnings in sales growth quarter-over-quarter-what you really want to see is the acceleration.

So maybe a company over the past few quarters has accelerated their earnings 20%, 25%, 27% then all of a sudden you see it jump to 50% and 70%, so you really get that kind of acceleration. That's usually, historically, what really makes the stocks take off.

I think the best example of that is Mellanox, the Israeli semiconductor stock. Looking at their earnings now, quarter-over-quarter, in 2011 they didn't even make money and their sales were growing at anywhere from about 20% to 40%. And then in the last four quarters, their earnings went from decelerating 7%, increasing 41%, 48%, 113%, and now 276%. The sales increase went from 52% to 59% to 80% to 79% to 61% and now to 111%.

You see they're really accelerating their top and bottom line, and the performance of the stock is showing that the institutions are really taking an interest in that. Those are the two most important things. There are other things that I look at, but if I had to pick two things, you want to see acceleration and sales earnings quarter over quarter.

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