What Not to Do in a Pullback

 | Apr 05, 2012 | 9:35 AM EDT
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Despite what appeared to be panic in certain quarters about Wednesday's selloff, a number of leading stocks I track were holding near their 10-week moving averages. Certainly, the downside action offered a signal for investors and swing traders to pocket some profits after the run-up in recent months -- and I am not dismissing the possibility of a real correction at this point. A pause to consolidate would not be surprising following the market's strong-up in recent months. After all, the days of heavy-volume selling on the major indices have been gradually piling up, and that type of action is historically a precursor of market tops.

However, as in any correction, the performance of market leaders will be key. As of Wednesday afternoon, many of the best price performers from the recent rally -- Apple (AAPL), Priceline (PCLN) and Lululemon (LULU) among them -- still sported healthy charts. In some of these cases, investors may consider selling to keep their gains, but in every market pullback I see people writing off strong stocks just because they've retreated from highs.

The points where I look for the next entry-point opportunities are the consolidations. Stocks that become the price leaders in a bull market typically have emerged from downturns that coincided with pullbacks in the major indices. I've seen too many investors miss out on eventual rallies in strong stocks because they became discouraged about prospects in a weak market.

So what's the best way to track leadership in the next correction? I watch stocks that continue to hold near key moving averages. For example, in last summer's market meltdown, Chipotle (CMG) found support above its 200-day moving average. In fact, it repeated that action in October and again in November. After clearing its final consolidation in January, Chipotle shares heated up, racing to all-time highs in the first quarter.

Also, throughout these downturns in recent months, Chipotle had a solid track record of revenue and earnings growth. While I use fundamentals in the process of sifting for stocks, I don't use them to time buy and sell decisions. Plenty of so-called "good companies" see their stocks turn south even while the fundamentals are strong. However, the fundamentals can often be indicators of more price gains ahead, so they are valuable as screening criteria.

While I'm continuing to track the current crop of leaders, which includes the stocks mentioned above, I'll also watch little-known names that are consolidating and see which may outpace the market even in a widespread pullback. As of Wednesday, small-caps on my watch list included Tyler Technologies (TYL), a Dallas-based provider of information technology services for government agencies. The stock cleared a short consolidation this week but, not surprisingly, it retreated with the general market. Its current buy point would be above $39.92.

Another name I'm eyeing is the low-priced Omnova (OMN). This is an Ohio company that makes specialty laminates used in floor coverings and paper, among other goods. This is one with which to be cautious, as it trades between $6 and $7 per share and has market capitalization of just $308 million.

The stock zoomed out of a base last month on enormous volume, and has held its gains, trading in a tight range over the past couple of weeks. Of course, being such a small stock, it has sparse analyst coverage. However, the ones who do track the company expect double-digit earnings gains in the next two years. As I mentioned, I won't make a buy decision based on that or any fundamental indicator, but it's a good indicator of the confidence level analysts have in the company at any given moment.

Currently, a new buy point could occur above $7.31, but that can always change if the stock forms one of several recognizable patterns as it consolidates.

Of course, market pullbacks leave investors with the task of making decisions about existing holdings -- whether to hold or sell. If an investor has a cushion in a particular name, sometimes sitting through a correction is feasible. In other cases, cutting losses quickly or selling with only small gains is the best strategy.

In any case, it can literally pay to continue running scans in order to see which stocks with good fundamentals are showing some support at or above key moving averages. These are frequently the names that emerge as the next crop of market leaders.

It often takes patience -- and it's not uncommon for a good performer to break down, particularly with earnings season set to get under way soon. But investors and traders who are long and get too discouraged in a market downturn often find themselves late to the party when the next uptrend begins.

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