Nothing Wrong With Bullish Action

05/11/2009 3:45 pm EST

Focus: GLOBAL

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

Paying up can pay off in a rising market—but beware those climax tops, writes Cabot China & Emerging Markets editor Paul Goodwin.

The stock market is always trying to separate you from your money. Everybody knows that. What some people may not know is that the market is equally good at separating you from your sanity.

My favorite crazy-making tactic is the issue that trades sideways for weeks and then breaks out with a 10% gain in one day. I tell myself that I can't buy it now because it's too extended. So I figure I'll buy it when it corrects tomorrow. Tomorrow comes and the stock continues to soar. Now I really can't buy it. And when the stock finally corrects for a day or two, it's so high above its moving averages that only a fool would buy it. 

I took a long, long look at Baidu (Nasdaq: BIDU) back in January when it dipped to 105, but it was just completing a retest of its November/December lows. But at the time, the Cabot China-Timer was flashing a red light and then, when BIDU began its new run, there were stronger stocks available. But now that I've watched it go all the way up to 246, I'm still regretting every day that it went up and I didn't own it. 

At $246 BIDU may still be a good stock [Baidu shares closed at $239.55 in New York Monday—Editor]. The Chinese market—especially the Chinese Internet market—is very strong and still has amazing growth potential, which means BIDU may be a great buy here. But the memory of that $105 low sticks in my craw and keeps me from looking at Baidu as just another growth company.

With the bulls firmly in charge of the rudder, it's a target-rich environment. With the Indian market up 23.0% for the last three months, the Chinese market up 22.7% and Brazil up 20.7%, there's money to be made in emerging market stocks. But regret isn't rational. I looked at BIDU at 105, and regret can chafe for a long time.

Stocks don't know you own them. That's the standard reply to anyone who's feeling paranoid because a stock they bought immediately fell on its nose. The truth is, though, that while the stock may not know you've bought it, the stock market does. Or, rather, the market knows when a bunch of people have bought a stock because the chart reflects the rising tide of buyers.

Growth investors are used to buying stocks on the way up. In fact, a rising chart is one of the things we screen for when we're looking for growth stocks. A rising stock can gather momentum as more and more people buy in to try for a piece of the action, and the rate of appreciation can steepen dramatically as a run continues. And if you're one of the investors who jumps on the bandwagon just as a stock is getting ready for its big correction, then you can say the stock knows you own it. 

The moral is to watch the climb rate and volume of a stock after a big run. If the price line starts heading for vertical and volume is waning, it's probably time to take some profit if you own it or keep your hands in your pocket if you don't. 

It's great that the stock market is healthy enough that people need to be warned about climax tops. It's a good problem to have because it's so easy to avoid and it says so much about the overall tone of the market. If you're in a market that's strong enough to pull money off the sidelines and build stocks up to the danger point, you're in an environment that can make you some money. 

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