Happy New Year! I’ve spent the last few issues looking back at 2011, and the trends and stocks that dominated the year. Now that it’s 2012, it’s time to look ahead!

Over the last couple of weeks, submissions have been rolling in for The Dick Davis Digests’upcoming Top Picks for 2012 issues. As I’ve mentioned here before, in addition to representing the very best investing ideas of proven experts, the Top Picks can also offer an in-a-nutshell glance at what analysts are expecting in the coming year. In addition, many editors have laid out their expectations for the New Year in their own letters. Combining these sources gives us a pretty good picture of what Wall Street is expecting in 2012.

Given the lousy last year, many of the predictions hinge on resurgences, revivals and rebirths.

The first rebirth could come from the housing sector, which, as everyone knows, has been a dead horse for the last five years, since the housing market collapsed. But 2012, some experts are saying, could be the year that these stocks begin to come back to life.

Check out the rest of Chloe’s thoughts in today’s Cabot Wealth Advisory.

Much like a roller coasters, the stock market produced plenty of action in 2011. And though I really like adventure rides, the recent action in stocks has brought a few too many sharp drops and loop de loops. The stock market, just like roller coasters, ended the year right where it started.

What about 2012? Well … we know that politics in Europe and the U.S. will continue to be front and center for a while. But unknown events will also come into play–some good, some not so good. And I think we can expect the U.S. economy to continue to struggle, while some emerging economies such as Brazil will do well.

My conclusion: the 2012 U.S. stock market will be similar to 2011, with lots of ups and downs. So strap yourselves in and get ready for a great ride. I would be a lot more negative if I let the front page news sway me, but I believe the foundation for stock market values is built on the outlook for sales, earnings and dividends rather than political banter, bickering and grand-standing.

Read the rest of Roy’s thoughts in today’s Cabot Wealth Advisory.

This week, I’m going to spotlight the year’s best-performing Top Picks.

Every year, we ask all of our Digest contributors to send us a recommendation of their single favorite stock to own in the coming year. Their submissions range from unknown small-caps to the past year’s winners, a broad range that reflects the wide variety of investing styles practiced by our contributors.

Once in July and again at the end of the year, we revisit the Top Picks to see what’s working.

As of this writing (just shy of the end of the year), the best-performing Top Pick, with a gain of 53%, is a small-cap technology company called Allot Communications (ALLT). Ian Wyatt, editor of Small Cap Investor PRO, recommended Allot, which made its gains in the first six months of 2011. So it was already a winner at mid-year, when Wyatt wrote in an update:

“I’m pleased with the continued growth of Allot Communications, which reported on Tuesday and beat earnings estimates by delivering EPS of $0.07. The company grew revenues by 38% over the comparable quarter of 2010, and by 6% sequentially. To bring more recent subscribers up to speed, Allot manages broadband networks to maximize their performance. Its customers are wireless cell phone operators around the world, and its competition includes companies like Blue Coat (BCSI) and Cisco Systems (CSCO). The company is growing because its solutions help service providers manage their networks more efficiently–its products solve the pains that come with an overloaded network. With massive growth in mobile technologies, I don’t see this trend ending anytime soon and believe Allot will continue to enjoy growing demand for its solutions. … There are now five analysts following Allot, and on average they believe the company will earn $0.26 in 2011 and $0.38 in 2012 on revenues of $71 million and $83 million, respectively. These projections would put revenue growth at 25% this year and 16% next. I think Allot will do better. I’ll bump up the price target on Allot to the consensus of $17.50–that’s around 15% higher than shares currently trade. Allot is a buy on weakness.”

Since then, Allot broke through the 17.50 level a few times, and even touched 19.15. Shares always meet resistance at those high levels though, and they are now back between 16 and 17. But as Wyatt wrote, this company is gaining admirers, and a strong move past 19 could signal the next phase of the upmove for ALLT. This is certainly one to keep an eye on.

The second-best performer to date is also a small-cap technology stock. This one doesn’t have any potential for new investors though: Global Defense Technology and Systems (GTEC) was acquired for $315 million in March 2011. The acquisition provided a quick 48% gain for subscribers who had bought the shares when Geoffrey Eiten, editor of OTC Growth Stock Watch, recommended them in our January Top Picks issue.

The third-best performing Top Pick is also a technology stock. But unlike ALLT and GTEC, IAC/Interactive Corp. (IACI) made fairly steady gains all year, even as the market thrashed up and down. Originally recommended in the Top Picks issue by David Fried, editor of The Buyback Letter, at 29.41, IACI is now trading in the low 40s. IAC/Interactive owns Ask.com and Match.com, in addition to other Internet properties. It’s hard to tell if the stock’s best days are behind or ahead of it–IACI’s momentum is choppy but upward, as evidenced by a pattern of higher highs and higher lows. Watch to see what IACI does when the market breaks out of its trading range in 2012 (hopefully to the upside).

The fourth-best performer overall was featured in Dividend Digest. Chunghwa Telecom Co. (CHT), recommended by Yiannis G. Mostrous in Global Investment Strategist, is up 35% year-to-date. Mostrous just updated his subscribers on Chunghwa Telecom last week, December 21, writing:

“Taiwan’s largest telecommunications provider Chunghwa Telecom in mid-December announced that its mobile communications division had crossed the 10-million subscriber mark. Chunghwa Telecom also announced that it would spend TWD6 billion (USD200 million) to boost its mobile network capacity–the first step on a path to cultivate a smartphone and ‘Internet of Things’ subscriber base of 10 million. Internet of Things refers to network-enabled objects, such as a refrigerator, and the web-based services that interact with these devices. In 2011, Chunghwa Telecom spent TWD4.8 billion (USD160 million) on expanding and improving its mobile network. The company also said it would contribute USD51 million to a consortium of Asian telecom companies to build high-speed submarine cables that will connect 11 areas in nine countries in the region. The Asia Pacific Gateway project will build an underwater fiber-optic network that will begin commercial service by 2014. The cables will stretch 100,000 kilometers and will link Taiwan, China, South Korea, Japan, Singapore, Malaysia, Thailand, Vietnam and Hong Kong. Chunghwa Telecom said that its November unconsolidated sales fell 1.34% year over year to TWD15.7 billion (USD519.9 million), without providing a reason for the decline. The company’s total revenue in the third quarter rose 9.5% year over year to USD1.9 billion, although net income declined 0.2% year over year to USD406.8 million. However, net income per American depositary receipt (ADR) rose 5% year over year to USD0.51, primarily due to a 20% reduction in outstanding shares. Chunghwa Telecom’s operating profit declined 3.9% year over year to USD473.3 million.

“The company’s mobile business accounted for USD810.2 million of total third-quarter revenue, an increase of 6.6% from the year-ago period. The company’s mobile subscriber base rose 4 percent year over year in the third quarter to 9.96 million, of which 5.83 million subscribers were third-generation (3G) technology users. These 3G users contributed to 40.5 percent yearly growth in mobile value-added services revenue, which came in at USD133.7 million in the quarter. The company expects its mobile Internet subscriber base to reach 1.47 million by the end of 2011 compared to 1.32 million at the end of the third quarter. The company’s Internet segment accounted for USD219.6 million in sales, up 0.6 percent year over year. The company is rapidly expanding its fiber network throughout Taiwan, with the aim of reaching 75% of the country’s population by the end of the year. The company’s broadband subscriber base was 4.48 million at the end of the third quarter. Of this total, 51.8% of broadband users had signed up for the company’s fiber network offerings. The company’s rapid expansion of fiber coverage allowed it to achieve 1 million movie-on-demand subscribers in November, one month earlier than predicted.

“Chunghwa Telecom controls 80% of Taiwan’s broadband market. The company is utterly dominant in the fixed-line market, holding a 96% share of the local fixed-line segment and 77% of the long-distance fixed-line market. The company’s domestic fixed-line segment grew revenue by 17.1% year over year to USD699.7 million in the third quarter, while the international fixed-line communications segment saw revenue decline by 6% to USD128.9 million. However, a recent government ruling has shifted the pricing right for landline-to-mobile phone calls in favor of fixed-line operators, which has boosted Chunghwa Telecom’s top line. Buy Chunghwa Telecom up to USD35.”

In addition to its appreciation potential, Chunghwa Telecom also offers large but intermittent dividends. Going forward, this company looks like a good pick for any investor.

During our lunch, we discussed the market and how pathetic the volume has been for stocks lately. Our conversation turned to options and whether there had been the same kind of drop off in volume. This simple conversation sent me down a path that led me to some pretty staggering findings.

After doing searches for volume data from the New York Stock Exchange (NYSE) and the Chicago Board Options Exchange (CBOE), I discovered that there is a major shift happening in the way investors view and use options.

Let’s start by looking at the volume on the NYSE. From 2005 through 2008, the average annual volume on the NYSE grew by over 10% per year. After the bear market from 2008-2009, the annual volume declined each year, with 2010 volume declining 19% from the 2009 volume. For the 2011 numbers, I used the average monthly volume for the first 11 months to arrive at a total for December in order to get a full year of data. As we enter the final week of trading, we are looking at another double-digit percentage volume loss for 2011.

What this suggests is that the average investor hasn’t come back into stocks at the level they were before the bear market. After dealing with two bear markets in less than 10 years, perhaps the average investor’s confidence is shaken and this is keeping them out of the market.

The next step was to look at the annual volume on the CBOE. Options trading grew by huge percentages from 2005-2008, with an average annual growth rate of 35% over the previous year. However, rather than declining sharply in the last three years, options volume declined by a much smaller percentage than stocks.

I have been trying to tell people for a number of years that options present a way for investors to participate in the market’s movements with far less money tied up in the market. Perhaps investors are starting to realize this and so options volume has been relatively stable over the last three years.

The final step in my analysis was to take the options volume and multiply it by 100 because each option represents 100 shares of the underlying stock. After taking this step, I looked at the options trades as a percentage of the stock trades. For instance, in 2004 there were 369.6 billion shares of stock traded on the NYSE, while 361 million options contracts were traded on the CBOE. In this case, the option volume multiplied by 100 came out to 36 billion shares of stock represented. The math from there is pretty easy as 36 billion is just under 10% of 369 billion. In other words, the amount of stock represented by options traded on the CBOE was approximately 10% of the NYSE’s stock volume.

So options trading grew faster than stock trading from 2005-2008 and then didn’t drop off as much in the last three years.

From the table above we see that the amount of stock represented by the options traded on the CBOE has increased sharply as a percentage of the stock traded on the NYSE. The number of shares controlled by options was just under 10% in 2004; in 2011, it’s estimated to be just under 30%.

Whether it is Main Street or Wall Street, investors have discovered that options present opportunities and strategies not available with stocks alone. With options, you can lower your total dollar exposure, but still participate in the market’s movements. You can use covered call strategies to add income to your portfolio or you can buy protective puts as insurance for your portfolio. But the view that options are only for risk takers is definitely changing and services like the Cabot Options Trader are becoming more sought out by investors. It has been 21 years since I made my first options trade and now more and more investors are realizing how options can play a part in their portfolio. It’s about time.

Editor’s Note: Don’t let the market’s volatility keep you out of investing. Use Rick Pendergraft’s Cabot Options Trader recommendations to make money in all markets … with less risk! Instead of missing out on winning trades, he uses the market’s volatility to his advantage and profits when most investors sit on the sidelines. Try a risk-free trial today!

As this is my last issue of the year, I want to first wish you and yours the very best of holiday seasons, and to thank you for reading my (and all of our editors’) musings this year.  We love what we do, and we’re thankful to have many faithful readers.

Now, on to the interview.

—

Elyse Andrews:  Mike, 2011 is winding down, and the market is hovering just about where it started the year.  As a student of the market, what do you make of the wild action and news that was 2011?

Mike Cintolo:  Honestly, Elyse, 2011 was one of the most challenging years I’ve ever been a part of or even studied, due to the whipsaw, choppy action that has been in place since mid-February; it’s been a series of two- to four-week moves, which have then been quickly reversed.  Effectively, our system revolves around trend following, both for stock picking and market timing, so these sharp ups and downs gave us little opportunity.

Even in past flat market years like 2005, there were two or three well-defined uptrends that, while not overly powerful, did provide some profits; I remember Google breaking out in April of that year and doubling within a year, and Apple was still a beast back then.  Even in some of the choppy years of the late-1970s, many small-cap indexes and stocks were actually in “stealth” bull markets.  This year, though, at least since mid-February, there’s been little money to be made.

However, one thing we’ve been kicking around in the office of late is the old adage, “The longer the base the longer the race,” meaning that the longer the market is effectively trendless, the longer and larger the move that comes out of it.  Thus, while I make no predictions about what will come next, I do feel confident in saying that, after nearly a year of trendless action, the market should get back to its trending ways relatively soon.  And that will be a good thing.

Elyse:  While you just said you don’t predict what’s going to happen, you have been laying out some scenarios in Cabot Market Letter lately.  What’s your latest thinking on what 2012 might hold?

Mike:  To be honest, Elyse, I am torn right now when looking at the short-term.  On one hand, if you look at the market from a bottoms-up perspective–meaning examining hundreds of individual stock charts–there’s not much to get excited about.  I see a few stocks setting up good-looking launching pads, like Rackspace (RAX) and MercadoLibre (MELI), or even bigger names like Google (GOOG) and Intuitive Surgical (ISRG).  But there aren’t many, and there are very few liquid, well-traded growth stocks that are near valid buy points, except for maybe GOOG and ISRG.

In fact, what’s worrisome is that most of the big, liquid winners of the bull market since 2009 look very toppy.  Some names like Netflix (NFLX) and Green Mountain Coffee (GMCR) have already broken down.  But others, like Baidu (BIDU), Priceline (PCLN), Wynn Resorts (WYNN), Lululemon (LULU) and Amazon (AMZN), all have set up big tops on their weekly charts it seems.  So that argues for another leg down in the market’s bear phase.

However, from a top-down perspective, we continue to think that the climactic selloffs in August and October, both of which brought more than 1,200 new lows on the NYSE, a very, very extreme reading, likely marked the peak in selling pressures.  That doesn’t mean we can’t have another leg down, but if we do, it’s likely that we’ll see some positive divergences–meaning that while the Dow hits a new low or comes close, the new lows might only rise to 600 or 700.  And that is something seen at nearly every major low throughout history.  Either way, the point is that we’ve already seen a huge amount of selling.

Put it together, short-term, I am torn.  Longer-term, my gut tells me that we’re already well into this bear phase–it’s been many months of nauseating action, and the major indexes already suffered 20% (for the Dow) to 30% (for the Russell 2000) declines, and, in my opinion, investor sentiment is horrible, telling you many are already out of the market. So whether we have another leg down or not, I am not anticipating another year or two of malaise, like 2000-2003 or 2007-2009.

Elyse:  Let’s hope you’re right!  In the meantime, as you wait for the market to begin a new, sustained trend, I know you’ve been sitting on a lot of cash.  Why don’t you try to play those two- to four-week swings you mentioned?  Can’t money be made that way?

Mike:  That is a great question Elyse.  There’s nothing wrong with taking a couple of small trades here or there; in fact, that’s what I’ve been recommending in Cabot Top Ten Trader lately.  After all, investors are really in the business of taking risks, and while putting all your chips on the table makes no sense here, it’s not like we’re in a 2008-style debacle where you have to be hunkered in your bomb shelter.

That said, the one thing investors need to be careful of is “system drift”–that is, instead of being intermediate- to longer-term trend followers (like we are), they suddenly become short-term, overbought/oversold swing traders.  Sounds easy, but in reality, it’s almost impossible to be a jack-of-all-trades investor; you’re better off knowing one system and knowing it very well.  I’ve seen a lot of people try to do this, change their stripes constantly, and they usually lose money because they don’t really know how to swing trade (to use this example) or, even worse, they get out of phase with the market–meaning they start swing trading, but then the market begins trending again.

Elyse:  That makes a lot of sense.  So, if you’re waiting for your pitch, as you say, what would it take for you to come off the sidelines in a meaningful way?

Mike:  Well, the short answer is strength–I want to see some decisive upside power in the market and, just as importantly, among potential leading stocks.  We’ve seen countless big one- or two-day rallies in recent months, but at no time has that coincided with great action among leaders; usually the buying has been among the stocks that have been hit the most, or among defensive stocks like tobacco and dollar stores.

So I want to see some real-volume buying, some tightness (as opposed to the wild up-and-down action we’ve been seeing) and some real breakouts among potential top stocks.  It sounds simple, and that’s the point–it is.  You can’t hide a new bull market.

As a last point, I will say that I am intrigued by this Tuesday’s rally, which occurred on heavier volume and saw a few stocks pop higher.  Still, I need to see more if I’m going to put any meaningful amount of money to work.

Elyse:  One thing you like to write about is improving your own investing skills.  What would you say are the top couple of lessons you’ll take from 2011?

Mike:  Oh geez, there are more than a few.  Like I said, this has been one of, if not the most challenging years I’ve had; not bad, really, but just difficult and grinding.  But the good news is that you usually learn a lot about yourself and your system under adverse circumstances.

I think the biggest thing that I re-learned was the importance of being selective.  It’s always good to force yourself to focus on only the best stocks with the best set-ups in the best environments.  It’s very difficult to do, especially when a stock you’ve been watching to set up goes nuts on the upside, tempting you to chase it.  But even in decent environments, many investors die a death of a thousand cuts–meaning they lose by taking a ton of small losses.  They trade too much!  So patience and backing off when conditions aren’t ideal is a good lesson.

Another “lesson” I’ve been thinking about is how you really do need a couple of good-sized winners to make good money in the market.  In a year like this one, bigger winners have been hard to find, which means any winner you had was relatively small.  And how many people have made good money this year with just those small winners?  Very few.  So it kind of reinforces one of our main tenets, which is to try to ride some stocks for big gainers.

And that sort of leads me into a third lesson.  Having read the above paragraph, many people will say, “Mike, what are you talking about?  If we tried to get big winners this year all we did was lose or, at best, breakeven!”  That is true, but what is also true is that every year is different–and what you want to avoid is learning too much from 2011.

Said another way, if you just examine this year, you’ll say to yourself “I should book every profit I get and buy on weakness and sell on strength.”  That worked this year, but my guess is that it won’t work nearly as well in 2012.  Thus, when analyzing your trades, don’t assume the market environment will remain the same; instead, try to identify any repeated mistakes from prior years so that you’re improving your system in a way that will help you in any environment.

Elyse:  Good stuff; I do feel like few investors really spend time to improve themselves, which is why they run into trouble again and again.  Moving on, besides sitting on their hands and remaining patient, what can the average investor do now so that he or she will be in the best position for the next bull market?

Mike:  First, work on a watch list.  I understand that it’s difficult to stay interested in the markets when they keep chopping around, and when the holidays are coming up, but keeping up on a handful of potential leading stocks is key.  Otherwise, you won’t know what to buy when the bulls return.  Right now, I’m most closely watching Google (GOOG), Intuitive Surgical (ISRG), Nuance Communications (NUAN), Rackspace (RAX), MercadoLibre (MELI) and some others as clues into the minds of institutional investors.  Just FYI, that list can change at any time.

Second, if you’re one of those investors that flies by the seat of his pants, now is a time to develop a game plan.  Think about how much you want to invest per stock, how much you’ll risk, when you’ll book profits, and so on.  I am not talking about some complicated, black-box Excel program here.  I am talking about a rough sketch of a plan that you can use to guide you when the bulls return.

Elyse:  We’re about out of time–do you have any other closing thoughts as we put a wrap on 2011 and head into 2012?

Mike:  Well, my biggest thought is that the market is no higher than it was in April 2010, no money has been made since mid-February, and the major indexes have already suffered top-to-bottom declines of 20% for the Dow and S&P 500, and 30% for some of the small-cap indexes.

Throw in the fact that investor sentiment is just awful right now, and I think it’s important to remember that this bear phase (or whatever you want to call it) likely isn’t in the first or second inning.  A lot of bad news has been priced in.  Everyone is aware of the potential problems in Europe.  That doesn’t mean we can’t have another leg down, but I as I said before, I don’t see another 2008 occurring.  Anything is possible, but the odds are against it.

With that in mind, now is a time to lean against the wind, at least mentally–don’t get buried in the worrisome headlines, thinking that the market can’t rally.  The investors who are going to make big money in the next advance are those that keep their heads up and continue the treasure hunt for the next big winners.  It’s been the same at every major bottom throughout history, and I’m sure it will hold true this time as well.

Editor’s Note:  Mike Cintolo is the editor of Cabot Market Letter, our flagship publication.  Combining top stock picking, market timing and portfolio management, Mike has bested the S&P 500 by more than 10% annually during the past five years–a period that encompassed bull, bear and choppy markets.  With a new bull market on the horizon, now is a great time to get in Mike’s program so you can take advantage of the leaders as they lift off.  Get started today!