A Much-Needed Reminder

Barely a week after some started worrying that oil prices were signaling a global economic crash, the Federal Reserve put on their Santa suit to calm skittish investors. The result was the two best days of the year for the Dow and S&P 500, as stocks made up lost ground and more.

The Russell 2000 has fared even better, leading me to suspect that the small-cap rally that historically starts in the third week of December will be gracing us again this year.

The blend of large and small stocks that make up our Breakout universe have come in somewhere in between. Our Buy List is up 2.6% on average since Friday’s close, overcoming all the aggregate weakness we had to suffer through last week, and the majority of our stocks are tracking above even the Russell 2000. Only two – First Acceptance (FAC) and Silver Standard Resources (SSRI) – are currently in the red this week, but I remain confident that we’ll see them turn around with time and both names remain buys at current levels.

This holiday miracle came courtesy of Fed Chair Janet Yellen and her colleagues at the Federal Reserve, who were well placed to give investors some cheer. But the substance of their statement is secondary to the way it reminded the Street of all the big picture truths that influence sentiment.

As far as anyone can see, the global picture has not changed since oil prices plummeted around Thanksgiving, when a lot of the big money was on the sidelines anyway. Growth in China has backed up a bit and fiscal conditions in the European Union remain a bit brittle. Both were drags on the market mood a month ago and neither situation has gotten appreciably worse.

Likewise, the U.S. economy continues to signal that it is healthier than it has been in years, with both GDP and the job market improving at robust enough rates to buoy corporate results and household budgets alike. That story hasn’t gone away. Now, after a relatively brief crisis of confidence, I think investors recognize this. While some macro moving parts have shifted, they again tend to support the bullish status quo narrative.

If anything, 20% cheaper gasoline than last year and the promise of even stronger fuel relief ahead may make this holiday season even brighter than anyone expected. Retail inflation was already flat in October and negative in November. Weaker commodity markets give the Fed even more room to keep liquidity on the generous side.

The precipitous drop in petroleum prices has increased the pressure on countries like Russia, Iran and Venezuela, which relied on expensive exports to soothe political tensions and keep their own oil-dependent domestic systems running. These countries were largely isolated within the global economy a month ago, and Russia in particular has become increasingly estranged from the West over the past year. Recent developments only accelerate that process.

So in this context, when Ms. Yellen reminded us all that the Fed will remain “patient” when it comes to tightening monetary policy next year, all that happened is that traders got a chance to take a deep breath and remember the reasons they bought their stocks to begin with.

Oil prices are still low but global demand has not gone over a cliff. Economic activity remains strong without looking anywhere near overheated. The Fed is more interested in protecting the market than punishing it. Stock prices have come a long way over the last year, but at a forward P/E under 16, the S&P 500 is at worst fully valued – it will take a bit more multiple expansion to become a bubble. Some stocks look richer than others and need to be sold. Others are still cheap and can support a little more upside before they catch up to their peers.

These are the closest things to eternal investment truths we have, and now that traders have heard the quiet, persistent voice of the Fed cutting through the noise, the fear and the gloom, it is clear that there was room for a little year-end rally after all.

Chart Focus: The Broad Market Bounce

These volatile times in the market when stocks tend to swing dramatically are when a more technically-oriented approach can help you make sense of the roller coaster. As you’ve seen, I’ve incorporated chart analysis into my Breakout recommendations to identify the best entry and exit points, and I plan to utilize them more in our 2015 strategy.

This technical approach can also give us a better idea of what exactly is behind the market’s behavior right now. Upon closer inspection, I wanted to share with you what I find to be the most compelling demonstration of the market’s underlying health right now.

Take a look at the S&P 500 over the last year:

Check out the green circles on the top study, which tracks the relative strength index (RSI) as the broad market has cycled from overbought to oversold conditions and back again. The higher the score on the RSI, the more traders have been indulging their hunger for stocks in the recent past. More demand for the same amount of equity means that prices have to rise to compensate, so it’s natural to see price action climb in sync with the RSI.

On the other side of the coin, a low RSI – any score below 50 – indicates weakening demand for stocks and increasing selling pressure. A reading below 30 reveals a security that is technically oversold, with selling getting far beyond its historical norms.

As you can see on the chart above, the S&P 500 has come close to that oversold line five times in the past 12 months, most recently just a few days ago. Each time came within a week of marking the broad market bottom.

While the RSI could always slide back into oversold territory from here, I find the initial rebound encouraging. So far this year, each rally off a similar RSI reading has left the market up an average of 8.5% from its bottom within two months. History rarely repeats exactly, but so far the outlook tends to support at least a cautiously bullish case – we actually have to go back to pre-2011 to see any kind of double-dip sell-off that would argue otherwise.

Now look at the green circles at the top of the RSI chart. Each of those incidents reflects a moment when the S&P 500 became technically overbought, which is simply a statistically-oriented way of saying that the market got ahead of itself. Each time, within six weeks, stock prices topped out and we suffered through a dip, with the most recent one coming in our post-Thanksgiving swoon.

While the RSI is not quite as accurate for forecasting the market top, it is clear that we are nowhere near that point just yet. At worst, it looks like the last few days have taken us halfway to the next near-term peak, wherever that turns out to be.

Our Strategy Amid the Volatility

While my stock recommendations are selected to avoid moving in lock step with the broad market, we have seen that the Breakout universe can truly catch a cold when the S&P 500 starts sneezing. Many of our stocks have suffered over the last few weeks even though their underlying stories were still strong – arguably even stronger than ever as they are now trading at a significant discount from their initial attractive levels. In most cases, they are bouncing back now and moving back on the right path for their upside potential to play out.

My goal is to keep our stocks from catching those colds and costing us weeks of waiting and anxiety. Take another look at that S&P 500 chart. When it starts looking unsustainably rich again, we will cut our vulnerable winners even quicker and slowing down on new buys until we get the green light to continue scooping up only the best bargains.

I’m already incorporating this chart-driven strategy into my current recommendations. After the pullback that took place shortly after we bought Vale (VALE) around Thanksgiving, I’ve held off on any new buys. The market has evolved too quickly and too erratically for me to be sure that I wasn’t asking you to catch any knives that still had further to fall.

Now that the air seems to be clearing and charts are indicating a better environment, I’m back to screening for new opportunities. As for VALE, I still really like this stock. The fact that it rebounded 5% this week is proof of what it can do in the right climate, so I continue to believe in its potential to reach our $11.50 target. VALE remains a buy below $9.75.

Revisiting Targets: CTIC, CRWN, FBP

We’ve been keeping a close eye on several of our Breakout names that have been trading near or even above their targets. While they’ve fluctuated a bit with the market, CTI BioPharma (CTIC), Crown Media (CRWN) and First Bancorp (FBP) are once again moving higher. Based on the sheer momentum on all three charts, I believe there’s further upside in each of these names still ahead before it becomes clear that they have achieved their full potential.

We were able to take advantage of this strength by selling Entravision (EVC) for double-digit returns earlier today, so I wanted to take a moment to update you on the rest of our strongest positions.

CTI BioPharma (CTIC) was actually trading in negative territory briefly before rebounding almost 10% to its close above $2.40 today. The picture has now improved to the point where CTIC looks attractive once again at this price. Given the stock’s impressive momentum, I am raising both my buy limit and target price, so buy CTIC under a revised $2.50 for our revised $2.75 target.

Crown Media (CRWN) is a slightly less bullish story, but if shares can push beyond current levels of $3.60, they could be clear to move toward our $4 target before the current rally fades. With the stock well above our $3.35 buy limit, I recommend that you continue to hold CRWN for a target of $4.

First Bancorp’s (FBP) fresh surge of momentum today pushed shares above our $5.70 target, but its chart continues to signal clear skies ahead. I suspect that the shares will be able to test $5.90 again in the near term, so continue to hold FBP and I’ll be in touch when it’s time to sell.

LIOX, STS, ISSC: Wait for Year-End Bounce

Along with our three strongest positions, three of our oldest positions were among our best short-term performers this week and I believe our patience will be rewarded with a good exit opportunity in the near term.

Both Lionbridge Technologies (LIOX) and Supreme Industries (STS) are rallying higher and moving closer to positive territory. It’s unfortunate that developments within each of these companies kept them from breaking out as I had originally hoped, but this week’s strength has closed the gap nicely.

I believe both names should perform well for us over the next few weeks, so keep holding LIOX and STS for a potential year-end bounce.

Innovative Solutions & Support (ISSC) has been a more difficult story on our Buy List, as the wounds from losing its huge Delta Air Lines (DAL) supply contract will be impossible to heal in any reasonable amount of time. At this point we are simply waiting for the current trend to peak so that we can exit in the strongest possible position.

It seems as if ISSC has finally converted long-term resistance into support for the first time since July, and I am increasingly optimistic that we can get out at $3, or possibly even higher. The goal here is to minimize our losses as we near the end of this stock’s wild roller coaster ride. This week’s 7% surge was a great sign, so let’s continue to hold ISSC.

With less than two weeks to go in 2014, it will be interesting to see how things play out as Wall Street shuts down for the holidays. With the market closed next Thursday for Christmas, I will send you a special holiday issue early on Wednesday, so keep an eye out for that. And as always, I will let you know my latest outlook on the market and our stocks in the Update Center in the meantime.

Sincerely,

Hilary Kramer
Editor, Breakout Stocks Under $10

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