The Gilmo Report

February 2, 2011

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The action over the past couple of weeks has been little more than the
stock market’s version of “ride the bucking bronco” as the sharp sell-off on
Friday went nowhere. The market essentially stabilized Monday with a
reaction rally and then flashed a follow-through type of day yesterday to get
everyone calling for a resumption of the market rally. As we see on the
NASDAQ Composite Index’s daily chart, below, the action has brought it
right back up to its recent price highs. While the deleterious action on
Friday got everyone thinking “correction” pretty quickly, the market did what
the market does best: It fooled everyone. In my view this follow-through
type of day yesterday is basically an “orphan follow-through” as it doesn’t
really define a market bottom, per se, and it could also end up fooling the
crowd. As I wrote over the weekend, a clarification of the severity of events
in Egypt would likely set up a market rally on Monday or Tuesday, and we
have seen that over the prior two days. Despite yesterday’s look of upside
thrust and power, the indexes were unable to muster any kind of follow-
through to the “follow-through” of yesterday as they essentially churned
around without any further upside progress. As well, I do take notice of the
fact that yesterday’s volume did not exceed the downside volume in the
indexes on the two big down-volume days over the last two weeks.

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It’s not clear whether this is a problem, but the bottom line is that I don’t see
a lot that is actionable here. The names that I’ve discussed as long ideas in
my prior two reports have done reasonably well, such as Halliburton
Company (HAL), which broke out last week, or Whiting Petroleum (WLL)
which flashed a pocket pivot buy point last Wednesday. Interestingly, the
action of the market has certainly given rise to more bearish sentiment, as
we can see on the Wall Street Sentiment Survey (©2011
DecisionPoint.com, used by permission) chart below. This is a weekly
survey of “a group of experienced traders and technically oriented market
analysts with a diverse set of analytical disciplines.” Notice that the past
three weeks have seen this group turn decidedly bearish, and this is
mimicked to a much lesser degree on other sentiment surveys. In general I
want to interpret the market’s action solely on its merits, but the sharpness
of the two-day rally this week does lead me to question whether it was
caused by the early “piggy shorts” getting run in. Who knows for sure, but
what I do know is that it is best to remain slow and methodical here, without
getting overly aggressive. I don’t see the technical damage of the last two
weeks as being entirely “healed,” so there is no need to rush in here as I
see it.

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Given yesterday’s appearance of power and strength in the indexes, this
naturally leads us to look at potential long positions here, but as I noted
above, most of the ideas I’ve discussed recently are extended. As it stands,
there are really only two big stocks that appear in a reasonable position to
buy and those are two recent buyable gap-ups in Netflix, Inc. (NFLX) and
Baidu, Inc. (BIDU). NFLX continues to weather a flurry of “bad” news, from
Amazon.com (AMZN) offering their own streaming movie service to Time
Warner mulling over whether to charge the company more for the content it
provides. So far, despite all the negative press and news, NFLX is holding
above the 204.58 low of the gap-up day, as we see in its daily chart below,
and it remains within buyable range. As long as it holds 204.58, your rough
guide for a stop, it is a playable leader here.

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Baidu, Inc. (BIDU) was not to be outdone by NFLX as it announced
earnings on Monday after the close and promptly gapped up the next day,
a buyable gap-up as we can see on the daily chart below. BIDU’s “udder”
formation served as a nice shake-out, as I noted in my report of January
16th, and then a pocket pivot type of reversal occurred eight trading days
ago as the stock held its 50-day moving average after selling off earlier in
the day, as I noted in my January 26th report. All of this led into Monday’s
earnings report and the buyable gap-up move of Tuesday. BIDU remains
within buyable range of the gap-up, using the 215.10 intra-day low of the
gap-up day as your guide for a stop. In my view, if yesterday’s follow-
through type action was an indication of further upside to come in this
market rally, then NFLX and BIDU should continue higher. If they get into
trouble, then that could bode ill for the market.

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One of the most interesting news-related situations this week was China
MediaExpress (CCME), which I discussed in my report of this past
weekend. CCME came under fire from a couple of blogs where the
company was proclaimed a “fraud” that does not even exist. This of course
sent the stock careening to the downside where it finally found some
support back at its 50-day moving average. However, as I indicated in my
report over the weekend, CCME’s breakout last week came from a flawed
cup-with-handle, as was quite evident on the weekly chart included with
that discussion. I get emails asking for my opinion on this, but the fact is I
have none. The base breakout was flawed, and I have not reconsidered the
stock since then. However, if this news proves to be just so much baloney,
then I would simply watch for the stock to set up again, this time with a
much sounder handle. This may take a fair bit of time given the technical
damage in the stock over the past few days, but the fact that it cannot hold
its 10-week (50-day) moving average here is not a good sign. The bottom
line for you to take heed of is that for now this stock is not in play, and it is
best simply left alone.

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If you like the obvious base breakout, then UK-based global mining stock
Rio Tinto Plc (RIO) is your ticket as it popped out of a thirteen-week-long
base that looks a bit like a “soup-ladle-with-handle” formation, as we see on
its daily chart below. RIO is a two-quarter earnings turnaround story with
earnings growth turning to a positive 34% in the past two quarters, but no
estimates are available going forward. This obviously presents a low-risk
entry point right here with the idea that it should hold the top of this base at
around $72 a share, roughly. RIO has been something of a laggard among
metals “stuff stocks” over the past three months, so perhaps this breakout
means it will now commence to play catch-up. RIO was a strongly trending
stock coming up off the August market lows, as we see in the chart, and
perhaps this recent three-month period of consolidation is what it needs to
resume its uptrend.

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I get plenty of emails asking me what I think of Daqo New Energy Corp.
(DQ), another one of these “too-good-to-be-true” little Chinese stocks with
huge estimates, huge earnings, huge ROE, and a very low P/E. DQ sells at
7 times forward estimates and is expected to earn $1.88 in 2011, an
increase of 114% over 2010. As well, this company shows insane
profitability with an ROE of 82.8%. The only question that this brings to
mind is why then does it sell at only 7 times forward earnings? That should
raise a warning flag, but that doesn’t seem to keep the stock from breaking
out here as it plows out of this short cup-with-handle type of base on big
volume today. This stock averages about 284,000 shares a day so it is
quite thin, and even with big volume like the 1.2 million shares we saw
coming in today it still didn’t trade over $17 million in dollar-volume. Another
thing working against DQ is the utter lack of institutional sponsorship, which
when combined with the 7-times estimates P/E ratio is another warning
sign. If you really want to play here, make sure to use $14 as a near-guide
for a very tight stop here.

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Despite yesterday’s action, I see no reason why this necessitates a mass
piling into the market on the long side right here and now. My recent
reports, even as the market was correcting and moving sideways over the
prior two weeks, identified low-risk entry points for a number of other
stocks, and they have acted well thus far. As long as these are working
there is no reason to start spreading one’s portfolio dollars around into
newer situations. If you get a good entry point, and the stock acts well,
such as we have seen in HAL or WLL, for example, then that is all you
need right here as yesterday’s “follow-through” does not represent a turn
off a major low in the market. Meanwhile, as I’ve noted, there was never
any significant short-side of the market to try and play over the past two
weeks as short-sale set-ups were virtually non-existent. Thus I think that as
far as individual stocks go, the best way to play any continued upside in
this market is as a cautious long. Play it steady, and pick your spots and
your stocks judiciously, and keep your stops clearly in mind.

Gil Morales
CEO & Principal, Gil Morales & Company, LLC
Principal and Managing Director, MoKa Investors, LLC
At the time of this writing, of the stocks mentioned in this report, Gil Morales, MoKa Investors, LLC, and/or Gil
Morales & Company, LLC held no positions , though positions are subject to change at any time and without notice.
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