Brace for impact! But while you duck for cover, keep your eyes on the prize…
All markets need to correct every now and then. It’s normal, healthy, and frankly necessary.
We got a taste of that early this week, with the S&P 500 falling 4% – the worst three-day decline since October.
It might not be what you want to hear… But right now, my data says stocks are headed lower for the near term.
So, in today’s essay, I’m going to go over why I think we’re in for some nasty volatility, and how to handle it. But just as importantly, I’ll show you why we’ll come out the other side of it better than ever.
The Big Money Index
To get a sense of the market’s near-term direction, I use my Big Money Index (BMI).
Regular readers will know this index is a chart of Big Money buy and sell signals over time. It basically tells us where the Big Money is going.
When the BMI line falls, Big Money is selling stocks. When it’s rising, Big Money is buying. And when it crosses the red line at the 80% level, stocks are overbought. When it crosses below the green line at the 25% level, stocks are oversold.
Take a look…
As you can see, the Big Money Index stalled out a couple weeks back. This means buyers were losing their control of the stock market. And since then, the BMI has deteriorated…
That alone should be concerning. When the BMI makes such a rapid descent after approaching overbought levels, that’s a big warning sign that stocks are headed lower.
But before you freak out and go sell all your stocks… Hear this. While the near-term outlook may not be pretty, I love stocks over the mid- to long-term.
Corrections are as natural and healthy as a fire to a forest. At first glance, it’s a terrible sight. But over the long term, it lets the underbrush clear out and pave the way for new growth.
With that in mind, let’s take a look at the biggest fears on investors’ minds, and why they’re only troublesome for the short term…
How We Got Here, and Where We’re Going
Let’s examine the fears currently plaguing investors’ thoughts…
- Peak earnings momentum. According to FactSet, 88% of the S&P 500 companies have reported earnings. 86% of those companies beat earnings estimates and 76% beat revenue.
That makes the Q1 earnings growth rate 49.4% – the highest since 2010.
While companies come out and continue to blow away estimates, many are getting sold. Why? The fear is that this is as good as it will get: The summit for earnings growth.
This is a legitimate worry, but only for the short term.
What you have to understand is outlier stocks – the types of stocks I target, more on that later – continually grow over time. Even if next quarter’s earnings aren’t such a blowout, companies with fundamental strength and Big Money buying interest prevail in the long run regardless. These two factors are the biggest ballast you could have in the market.
- High valuations. The current price-to-earnings (P/E) ratio for the S&P 500 is at 45. That’s three times the 150-year average of 15. That’s got investors freaked out.
But the forward 12-month P/E ratio – which measures future performance estimates, rather than past performance as the standard P/E measures – is 21.6. That implies investors expect earnings to come in line with price in the next 12 months.
It’s simple arithmetic. Price divided by earnings. Prices are rising – but earnings are rising faster. But what a lot of doomsayers don’t understand is that P/E’s will fall not because stock valuations will fall to meet earnings, but the opposite – earnings will rise to meet the valuations.
- Taxes. The only other thing as certain as the earth’s rotation…
A couple weeks back, I wrote to you about Biden’s plan to hike taxes primarily on $400k+ earners and corporations. He’s also mulling hiking long-term capital gains taxes.
This stirs the hornet’s nest among high-net-worth investors and spooks the market lower. But, we can’t forget, Democrats must win midterm elections next year. Sinking the economy and attacking dividend income that old ladies need to survive might not curry favor.
I think this is a tough-talk tactic: Come to the negotiation table with big demands, prepared to leave with less. That would still be a victory for the Democrats.
Plus, historically speaking, higher taxes hardly ever correlates with a falling stock market. According to a Fidelity study, 12 out of 13 times since 1950, the S&P 500 rose the year prior and during a tax hike. Stocks rose 100% of the time corporate taxes rose.
- Seasonal volatility. Have you ever heard the phrase “sell in May and go away”? Investors seemed to remember it last week…
Seasonal summer volatility is real. Investors don’t like volatility, but that’s what makes a market. What goes up must come down, and neither direction usually comes in a straight line. However, this seasonal volatility will pass in time, and make for a bullish rest of the year in my view.
Of course, not everything is falling right now. Let’s take a look at where the Big Money is moving its chips…
Here’s what I see: Big Money is mainly buying value stocks and “reopening” stocks (that’s materials, energy, industrials, financials, communications, discretionary, and staples).
Meanwhile, Big Money is selling growth stocks (namely tech and healthcare).
In other words, the companies doing the best are getting hurt… While the ones expected to do better are getting praised.
How to Play It
There’s no question… Stocks are the place to be for the long term. No other investment has done better over the past 100 years.
What’s most interesting, however, is that only 4% of stocks are responsible for 100% of the gains of stocks above treasuries since the 1920’s. That was proven by Hendrik Bessembinder in his paper “Do Stocks Outperform Treasury Bills?”
I call this 4% of stocks “outliers.” And focusing on finding those is how you beat the market.
What shouldn’t surprise you is that you often find these outliers in growth stocks. These are the companies that grow their earnings and revenue year after year, while keeping debt manageable, and are leaders in their business sector.
For now – the data says stocks may head lower. But based on yesterday’s big bounce things can always turn on a dime. Either way, my plan is the same: Buy great outlier stocks on discounts – and win long term!
If you want to get broad-based exposure in high-growth companies, I would suggest an exchange-traded fund (ETF) like the SPDR S&P 500 Growth ETF (SPYG), which is focused on these stocks.
If you have the stomach to buy growth stocks after this recent fire sale, and to add to your position if it heads lower, time will reward you.
Storms bring fear and uncertainty. But there’s always calm after the storm passes. The trick is to know where to find opportunity where everyone else overlooks it.
Editor, Outlier Investor