A Steep Tumble Could Be a Good Thing

 | Apr 29, 2014 | 12:31 PM EDT  | Comments
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Stock quotes in this article:

jdsu

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pcln

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amzn

Yesterday on Real Money and last night on Mad Money, Jim Cramer brought some great coverage on the breakdown in momentum names. Helene Meisler has also offered up some great charts and thoughts on the subject. I would even venture to say Helene was first in mentioning this, so maybe my thoughts here are just an echo, but that's really what we are talking about with these comparisons: echoes.

Past charts and patterns constitute nothing more than an echo. After all, when we hear an echo, it isn't the first time the words have been uttered. In addition, we are usually only hearing part of what was said -- and, as time passes, we will hear less and less of what was originally said. This is exactly what historical chart patterns are doing.

For instance, we continue to make comparisons to 1929, but it seems as if the comparisons fade more and more each time they arise. Now we are comparing back with the 2000 time frame. We've already seen this similar pattern repeat in 2008 and 2009, so now we have a second go-around. That's not all bad. Actually in this case, it is probably a good thing.

As echoes dissipate over time, so should the similarity of the chart pattern. So, while we allude back to 2000, any drop, while similar, shouldn't be severe. In fact, I am not calling for a drop that's similar to what we saw in 2000 -- but even if the echo is fading, we can still learn from it.

Momentum Names -- Weekly (1999-2003)
Source: StockCharts.com

For instance, when we look back to what happened to some big names from 1999 through 2003, we see how big moves can not only be erased, but also turn into major losses. JDS Uniphase (JDSU) soared 1,500% before bottoming at a loss of 64.53% of its value since the start of 1999. Internet Capital Group topped up 1,100% before it gave back all those gains, along with another 97.5%. Even Priceline (PCLN) found itself down 96% from its 1999 value for quite some time.

Momentum Names -- Weekly (1999-2014
Source: StockCharts.com

Fast-forward to the 2000-to-2014 period, though, with this same group of stocks. Priceline has not only recovered its losses, but has now rallied more than 200%. Then again, if you had managed to buy Priceline in January 2003, you would have been up some 14,000%. Amazon (AMZN) has some ridiculous number well. Of course, JDS Uniphase and ICGE have never really recovered.

Amazon (AMZN) -- Weekly, 2000-2004
Source: StockCharts.com

In other words, if we do get a rout -- one in which some of these big momentum names give up another 50% from current levels -- there could be some absolutely huge winners over the next decade. I'm talking about the kind of winners that truly create wealth for those willing to hold the names.

On the flip side, there will also be some stocks that simply never recover. A pullback of 30% to 50% is almost a worst-case scenario, in my view. If we look again at what happened in 2000, such a loss leaves too much potential downside, with not enough upside. But it doesn't take too many 14,000% winners, or even 5,000% winners, to make up for four or five 90%-plus losers -- as long as you take equal entries into all the names at similar times.

In the end, another big push lower could be great for those with a longer-term view. Put together a group of eight to 10 names and buy them all equally. The twist here -- and it is almost ironic coming from me -- is the choices need to be based on fundamentals. Don't buy the concept stock. Buy the names that business model that are significantly growing revenue, that have little or no debt, that are profitable or at least cash-flow positive and preferably those with a high barrier to entry. There are obviously other factors to consider, but I would start with those metrics.

One great technical takeaway from the 2000 time frame is the use of the weekly charts. The 20-week and 40-week simple moving averages, in particular, are key. Yes, they are very similar to the 100-day and 200-day simple moving averages, although they are not exactly the same.

To keep things simple, a price that moves below the 20-week SMA should signal a yellow flag, while a drop below the 40-week moving average would be a red flag. Once the 20-week SMA crosses beneath the 40-week line and the price sits below both, it is time for an investor to step aside, no matter how compelling the fundamental story is. At this point, stepping aside could also mean spending some money to completely hedge off any downside exposure through puts. But when this occurs on the chart, it is time to say, "Enough is enough."

Still, it may create trading opportunities on bounces. For instance, a trader could buy on a break of price above the 20-week SMA, but they should be prepared to sell as soon as price gets near the 40-week. Furthermore, the stock should become a longer-term buy once the 20-week SMA crosses back above the 40-week line, and the latter should now be used as a stop or hedging area.

Rinse, repeat and maybe catch a multi-thousand-percent returner if the stuff does hit the fan and we hear the distant echoes of 2000 once again.

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