Relative Strength

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The graph at the top shows the relative year-to-date (YTD) performance of the indexes and the LED stocks we've been following. The chart at the bottom shows how far off each stock is from its recent highs. While the indexes are basically flat for the year, the LED stocks are still way ahead of the game. This may be little consolation to those who bought in more recently.

Another thing can be deferred from these charts, and it happens to be the most important thing going ahead. One stock stands out as the clear leader in relative strength... RBCN.

RBCN has not only outperformed the others on a YTD basis, it has also fallen less than any of the others from recent highs. This is spectacular when you consider how contradictory this is. The stocks that do very well (have the highest momentum) usually correct the most. RBCN has managed to post impressive gains AND resist giving them back. This leads us to believe that the stock is in strong demand, and will emerge from this correction with explosive strength, posting tremendous gains over the next several quarters. It is our belief that smart money is flowing into RBCN, giving it its incredible resistance to decline. In an ideal world, we would now be blessed with a few sessions of capitulative selling which brings RBCN into the low 20's or high teens, at which point we could back up the truck. Opportunities like this are rare, but in a nutshell, they are what the other 70% of our portfolio is for.

This all takes great patience, but in time it will all make perfect sense.

VECO

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VECO & AIXG fell today, supposedly on "news" that Applied Materials and Samsung are going to enter the MOCVD market. We frankly don't care what the "news" is, or what it means to the company. All that matters to us is the chart and the earnings. The chart has been showing increasing signs of waning strength versus the other LED issues. We traded in almost 2/3rds of our VECO holdings for shares of CREE and RBCN yesterday based on this relative strength issue. We did not have advanced knowledge of today's impending "news". Approx 12% of our portfolio is still invested in VECO. So where do we go from here?

First we look at the chart. The chart is at a very critical point, resting on a fairly long term trend channel. This trend channel was reiterated by its moving average until its recent rally took it well above its normal trading range. So we don't have a moving average to rely on, but we do still have the channel. Either VECO will rally strongly from here, solidifying the support its channel has created, or it will break down hard. One of these outcomes could happen as early as tomorrow, or it may happen after the stock trades around this support area for some time.

Either way, our discipline is certain... we let go of stocks that break down hard and close at their lows (intraday spikes don't count, especially if brought on by a spike in the broader market). Regardless of what they do after decisively breaking down, we sell and never look back. We try to always look to the future rather than dwell on the past. Right now, until/unless they follow suit, CREE and RBCN look very strong relative to the market, and we will continue to buy them on dips instead of buying back into VECO.

The psychological aspect of this is as follows... stay focused on the goal. The goal is not to have made a good trade on an LED stock, namely VECO. The goal is to double the money you've invested in the LED sector during the craze before it's over... then find the next craze and do it again. Finding the stock that will make that happen is never easy. Nor is the discipline required to trade in a way that will make that goal a reality. Keeping your capital invested in the highest relative strength stocks in a strong sector is a sure way to beat the market. But you have to be flexible, and remain focused on what your bottom line will be in December, not what it will be next week.

We will continue to closely watch CREE and RBCN for signs of high relative strength, or waning strength, whatever the case may be. As for now, neither stock is disappointing on that level. Although both are off their highs, they are both higher than they were on April 1st, which cannot be said about VECO, MRVL, AIXG, or the indexes.

Relative Strength

Periods of market weakness are the best times to judge a stock's strength, especially relative to others in its sector. Yesterday, VECO was the relative strength winner in the group. Today, CREE and RBCN are coming on strong. One day does not make a trend, so we'll have to keep an eye on this race. We feel that relative strength is the single most important characteristic a stock can have, and that it is therefore the greatest predictor of future performance.

If CREE & RBCN continue to outpace VECO (not in gains but in strength relative to the market), we may just shift our position from VECO to a combination of the two. It's too early yet, but there's no doubt at this point that CREE, RBCN and VECO are far outpacing their weaker counterparts, AIXG and MRVL. Now with only three stocks in the running for "highest relative strength LED issue", it shouldn't be too hard to choose which will be the top dog during the market's next leg up.

VXX

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Some time ago, we predicted that the market would trade in a wide range for the next several years (something like 7,000 - 10,000). We still believe this, and given recent events, we believe that the market just put in the top of this range. Now to find out where the bottom will be!

We ran into two of our well-respected Wall Street hedgies this weekend and asked them both where they thought the market was headed. One is a long term thinker and his reply was, "over the next 4 to 5 years... much higher". He did not seem in the least bit concerned with what happens over the next few months. The other told us that he sees the market going much lower. He admitted, though, that he was on the wrong side of the trade during the market's recent upside. He said he's been a bear on the market for a long time, and continues to be. He suggested not choosing sides and instead trading the VIX.

Given that our chats were inconclusive (one bull and one bear), we have to rely on our own spidey sense. Our guess is that given everything the market is facing right now, it'll drop to about 8,000 or so (lows of last summer), to mark the low for its new trading range. But that's just another two days of trading, so why fret?

We probably should not be 33% invested at the moment, and we may trim that percentage a bit if the market rallies. Otherwise, we're just going to remain focused on the intermediate term (end of year), and use this time to increase our exposure in companies with great promise. We still stand firm on our belief that the LED stocks will double by year end from whatever lows they make during this correction. Perhaps CREE from 55 to 110, or VECO from 35 to 70, whichever it may be, that's too large a gain to miss out on. We still strongly believe that these stocks have not put in their tops just yet, and that belief is rooted in our theory that they will not top out until a few quarters (or a year) before their earnings growth tops out. Given the size of their market, we don't think they've reached that point yet.

That said, we're still not willing to pay up for these names. We want them cheap. If the market drops 800 points one of these days, we'll be buying, not selling.

Along with our focus on buying low, we're also going to take hedgie #2's advice and play with the VIX. For those unfamiliar with trading the VIX, you should know that you cannot but the VIX directly. Instead, there is an ETF called VXX which tracks it. The chart above is a chart of VXX.

After the market calms down for a few sessions, this index will drop. During market corrections, the VXX goes sideways in a broad range, making very rapid swings from its lows to its highs. This makes it a great trading vehicle. Buying VXX anywhere in the low 20's looks to us to be a sure winner over the next couple months, as we agree that market volatility is here to stay until at least the next quarter. Buying VXX in the low 20's (if possible), is perhaps the best insurance policy against a market crash. There is little downside, because for it to drop significantly, traders would have to reach a point of complacency. Given the events overseas, our own struggling economy, and the market's recent large gains, we just don't think traders are going on vacation anytime soon.

For better or worse, here's our prescription...

-Cash is King. (have at least 2/3rds of your portfolio in cash).

-Use this correction to get bargains on strong growth stocks that you plan to hold until year end.

-Hedge your portfolio with a bet on continued volatility by buying VXX on dips.

S&P & VECO

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The chart at the top is of the S&P index. The market has gone from one of "buy the dips" to one of "sell the rallies". If this is another healthy correction, then the S&P could retrace to approximately 1100. We believe this is just another healthy consolidation period for the market as opposed to anything more substantial. It's perfectly reasonable for the U.S. market to tread water for some time, given the uncertainty overseas. While we may see some dramatic 200 - 300 point one-day losses for the Dow, in our mind it's just treading water given the huge upside it's experienced lately. No doubt the next few weeks will offer some excellent buying opportunites. One thing we always remind ourselves during market corrections is that they are the best time to see relative strength, and that the strongest stocks will hit bottom long before the market itself. A strong stock could hit bottom next week, even though the market won't hit its lows for another month. This is often how investors miss the bottom, expecting that both the stocks on their wishlists and the market indexes will bottom out together. This isn't how it works. If you've chosen strong stocks, you should be starting to buy in very soon.

The lower chart is a chart of VECO. We're staying put with our position, although we know there may be more pain ahead. We're looking to buy more LED stocks in the days/weeks ahead. We'd like to get back into CREE, which we sold some time ago at around $76. We still feel it's overvalued, and will remain stubborn about not paying up for these shares. Stocks with low EPS's (high P/E's), such as RBCN and MRVL, are getting hit particularly hard because during corrections, stocks revert to fair valuations based not on forward earnings, but on current earnings. In this regard, we feel VECO is a bit of a safe haven, and any undue selling pressure will present a buying opportunity. We may be wrong on VECO, but we don't have enough reason to turn against it at the moment. With a P/E of 15, there's no reason for us to sell into weakness.
The only other trade we're considering is one in the Ultrashort indexes, like SDS, QID, or DXD. We are not looking to start this position at the market's current level, but if the market rallies strongly, we'll have to assume that it's a bear trap and buy into one of these. The current market downturn is not likely to end quickly, as macro-economic uncertainty such as what's happening overseas takes many quarters to work its way through. There is no reason, however, for the U.S. market to trade in sync with the overseas markets. The U.S. will likely pull out of the downturn quicker, with our strongest sectors eventually rallying so quickly that anyone not invested will have a very tough time getting in. It is our belief that the LED stocks will roughly double by year end from their Spring lows. These lows, whatever they may turn out to be, will be put in sooner than most traders expect.

Our Take On VECO

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It always amazes us how little patience some investors have. If you read the message boards, you'd think VECO is going out of business. What's wrong with a stock, or an entire sector for that matter, correcting after months of phenomenal gains? In our view, absolutely nothing. Volatility goes hand-in-hand with growth stocks. As long as a chart stays above its uptrending moving average and hasn't broken down below the bottom of its trend channel, then we really don't care what it does above those lines.

We see VECO as a company poised to experience significant growth through some time in 2012. If we didn't already own it, we would have bought some today. We fully accept that at some point these LED stocks will reach a plateau where their future growth is calculable, and that will end their 15 minutes of fame. But until you personally buy your first LED bulb, don't worry about the LED craze being over. It's already a foregone conclusion (not to mention a government mandate) that every lightbulb in the world will be changing over the next 4 years. It isn't until you're in some random deli overhearing people talk about LED stocks that you should fear their run being over.

The big-picture thinkers, like Peter Lynch, suggest that you should never look at charts with intervals of less than 5 days. That is, charts where each bar represents a week of trading. The logic behind this is that it keeps you focused on the longer term picture, where blips like this are hardly visible.

Buffett would tell you that if you liked the stock yesterday at $54, then you should love it today at $47. How true that is.

Let's stay focused on the big picture and not let the short-term thinkers and window dressers distract us.

VECO

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(This post has been updated to reflect VECO's latest guidance)

Time to re-evaluate VECO. The chart shows that it is either well above the top of its channel, or it has simply started a new channel. This is an arithmetic chart, so "going parabolic" is not unusual for the strongest growth stocks. It's when a stock goes parabolic on a logarithmic chart that you need to run for the hills. Going solely by the channel and moving average, VECO is overbought and ripe for a correction. It is only an immediate cause for concern if its fundamentals tell us the same thing, so let's take a fresh look at them...

Over the past four quarters, VECO has posted earnings of

-.15, .16, .41 & .49, for a current EPS of 91 cents. Next quarter, VECO projects to report earnings of 78 to 90 cents per share, well above the 59 cents previously expected by analysts. For the purpose of our calculations, we're going to assume VECO will report 85 cents per share next quarter.

No one really knows how well the LED companies will do, as the number of lightbulbs in the world is an incalculable figure. History has proven, though, that during their most aggressive growth phase, companies grow by approximately 20% to 30% annually for about 5 years at a time. Beyond that, growth at that rate is unsustainable. We therefore typically use 25% as our estimate for a company's EPS growth, so as not to get caught up in a Dutch Tulip bubble.

This number should be scaled up or down depending on the size of the company. For a company VECO's size, an estimate of 25% to 30% is acceptable. As an example, we might use 20% to 25% for a company the size of CREE, and 15% to 20% for a company the size of AAPL.

This estimate yields a P/E for VECO of 30 to 36, using a PEG ratio of 1.2. As we've said before, Buffett supports the use of a PEG ratio of 1.2, so who are we to play with that number?

Using VECO's current EPS, it should be trading anywhere between $27 and $33. If we had a broad market correction right now, this may be where VECO would retrace to. And it would be a steal at that. But who goes by current EPS figures?

Looking out 3 months, VECO's projected EPS ($1.91) suggests it will be worth anywhere from $57 to $69. Even if we go with a more conservative growth rate like 20%, we'd be looking for VECO to be priced at around $48. So we don't feel that there is a lot of downside in holding VECO here, despite how "nosebleed" the chart appears.

Looking out two quarters, the 15 cent quarter will be replaced perhaps by another 85 cent quarter, giving VECO an EPS of $2.61. At that time, VECO could be trading at around $80 per share.... maybe even higher if the market is surging at that time.

Our approach going forward is going to be to hold VECO and add on dips. Of course there is a number at which we would sell, but as long as it stays below $60 or so, we won't even be considering it.

In another note, we continue to believe that the market is blowing off and about to retrace significantly enough to give us good entry points on just about every issue.