Rules of the Game: Don't Fear New Highs

 | Apr 25, 2013 | 12:00 PM EDT  | Comments
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It's never a good idea to dismiss a stock simply because it has rallied to new highs. While that's not the ideal place to buy, too many investors maintain a permanent "do not touch" policy when it comes to a stocks, or even entire sectors, that are soaring to new high ground. 

Another mistake I see frequently: Investors avoid stocks that were highfliers in a previous market cycle. After the stock retreats -- sometimes in a spectacular crash -- investors wrongly believe its best days are behind it.

My friend Gennady Kupershteyn of Kupershteyn Advisory Group emailed me earlier this week with some tech names that are potentially setting up to reach their highs from the late 1990s or early 2000. He noticed that many of these stocks hail from the info tech (and related) and biotech industries.

Let's take one example: Western Digital (WDC), a maker of hard disk drives, got within $0.22 of its 1997 peak of $54.75. The technicals do look promising, as the stock has been getting solid support near its 10-week moving average since December.

Western Digital reported its third quarter after Wednesday's close, beating on the top and bottom lines. The stock rallied nearly 4% after hours, to $55.

Another tech name at multi-year highs is ARM Holdings (ARMH), which I've written about here recently. The U.K.-based company designs chips that are found in an array of mobile devices. After the company's better-than-expected first-quarter report, the stock gapped up 15% on Tuesday.  

It gave up some of those gains Wednesday -- not an unusual phenomenon, as some traders pocket profits after a big move. Like Western Digital, ARM Holdings is a high-beta stock, exactly the kind that can deliver hefty price gains in a rally but decline just as quickly. A glance at the daily chart shows numerous intraday gaps. ARM Holdings an American depositary receipt, so the gaps often reflect currency exchange rates rather than investor indecision.

Analysts expect earnings to grow 25% this year to $0.89 per share, and another 27% next year to $1.13 per share. That indicates Wall Street's level of confidence in the company, but be aware of valuations that indicate a stock may be priced for perfection. ARM Holdings' price-to-earnings ratio is 81, indicating that there may be some loftiness in the stock at the moment.

While momentum investors and traders like to see upside strength before making a purchase, it's foolhardy to chase a stock at new highs. I've written many times about the wisdom of waiting for a pullback (also known as a "buy opportunity").

Kupershteyn, who doesn't shy away from high-beta growth stocks, also says caution is in order while many of these stocks levitate near new highs. He notes that investors often get so caught up in a company's story that "they are willing to pay any price without regard for current valuations."

Numerous other stocks are perched near their peaks. While many have potential, investors may be well served to step away from the "buy" button at this juncture and wait for a pullback with moving-average support.

While so many stocks make pronounced moves on earnings, Kupershteyn has identified other erstwhile growth leaders as being extended at the moment. Later this week, I'll highlight some additional names as watch-list candidates, although not necessarily appropriate buys at this moment.

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