A funny thing happened to my Bauman Letter and Profit Switch inboxes during the latest market pullback.
Sure, I got some emails about specific stocks that are down more than others.
But I haven’t received a single email asking me if we’re on the verge of a market crash.
That’s a great sign. It tells me you’ve absorbed the central lesson of the last decade: Stocks mostly go up; sometimes they go down, but then they go back up again.
People who lived through the great dot-com crash of 2000 know this. We were reminded in the great financial crisis of 2008 to 2009.
Since then, we’ve seen corrections — defined as a loss of more than 10% — five times. In 2010 the drawdown was 16%. In 2011 it was 19%. In 2015 the damage was 12%. 2018 saw a 10% drop, and last year investors saw markets slide 32%.
Every time, the market recovered. The only people who lost money were those who sold in a panic.
But very few people invest in the entire stock market, at least not as their main investment.
Most people spread their portfolio across a variety of sectors. Many of them also follow “momentum” strategies. This involves buying stocks that are going up and selling those that are going down.
That’s a great strategy. Until it isn’t.
Eventually momentum shifts. Stocks that were doing well before, stop doing well. Those that weren’t so hot suddenly perk up.
What’s an investor do then?
The answer is counterintuitive…
The Pushmi-Pullyu Rotation
The chart below shows two versions of the S&P 500 Index, versus the Nasdaq 100, comprised of the top technology stocks. One version of the S&P is equal weighted, the other is weighted by market capitalization.
The first thing to note is that investors have rotated strongly away from technology stocks (red line, down 2.2% year to date [YTD]).
The second thing is how much better the equal-weighted version of the S&P 500 (up 9% YTD) is doing than the standard version, which is weighted by market capitalization (up 3% YTD).
The explanation is that because technology stocks have such a huge weighting in the S&P, they’ve dragged back the overall index. But many companies with smaller weightings are doing very well.
That’s why the equal-weighted version (green line) is breaking away from the others:
This chart shows that what seems like a pullback in the stock market is actually a reallocation of money. Investors are moving away from previously leading sectors — namely high-growth technology — and toward other sectors.
It’s a rotation, not a pullback.
But it’s a violent one, for two reasons.
First, the Federal Reserve slashed interest rates to the bare minimum last year. That, combined with the devastating effects of the pandemic on real-world companies, prompted investors to pour money into high-growth tech stocks. Their valuations rose because people were willing to pay more and more for companies with small or even no earnings at all.
Second, we’re coming out of a period of extremely low earnings for real-world companies, especially in sectors such as energy, leisure and hospitality which were pummeled by the pandemic. Now that the vaccine drive is picking up steam and Congress has passed a massive stimulus bill, the market expects that to change quickly.
The overall effect is like Dr. Doolittle’s mythical Pushmi-Pullyu. Tech stocks are getting pulled down, while cyclical sectors are getting pushed up — much faster than usual.
How to React to the Rotation
I mentioned earlier that momentum trading strategies buy more of what’s going up and sell more of what’s going down.
You should definitely not do that right now.
Instead, my recommendation is that you buy more of what’s going up and some of what’s going down.
It’s definitely a good time to buy companies held by exchange-traded funds (ETFs) such as the Energy Select Sector SPDR ETF (NYSE: XLE) and the SPDR S&P Bank ETF (NYSE: KBE). Those companies are getting pushed up by the vaccine/stimulus recovery trade.
But, counterintuitively, it’s also a good time to buy more of the companies that have been pulled down by this rotation, lower your average cost basis and set yourself up for bigger profits in the future.
The trick is to be judicious about it. All you must do is follow two simple rules.
Rule No. 1: Don’t buy more shares of outrageously overvalued tech stocks with uncertain growth prospects.
Zoom (Nasdaq: ZM), for example, has a price-to-earnings ratio of 144, and a price-to-sales ratio of 37. But its pandemic tailwinds are fading, and competition in the online meeting space is heating up, with new offerings from Microsoft, Google and several smaller players. If you bought early last year, you’d probably want to take profits now. Buying more now and hoping for a recovery will likely involve a long wait.
Rule No. 2: Double down on tech stocks with strong secular tailwinds. Take advantage of the dip to lower your average cost basis.
This is a more difficult rule to follow. That’s because it involves assessing the prospects of companies that are still unprofitable but have growth prospects the market hasn’t recognized yet.
For example, I’m bullish on electric vehicles (EVs). But I wouldn’t touch Tesla (Nasdaq: TSLA) with a 10-foot pole. There just aren’t any fundamentals-based gains to be had. And I’m wary of Tesla competitors focusing on the high-end sedan market. There are too many of them, and the market is too limited for them all to succeed.
But there are numerous EV companies operating in niches few investors are thinking about. For example, any company with demonstrated manufacturing capability developing an EV for fleet use is worth a good, hard look.
Public and private bulk buyers will be loading up on EV police cars, utility pickups, buses and urban delivery vans over the next few years. The Biden administration has a clear policy of electrifying the federal fleet, and Congress is poised to enact incentives for other public agencies.
Compared to the free-for-all in the private sedan EV market, this is a real opportunity.
You’ve Shown You’re Tough, Now Be Smart
Our motto here at the Bauman Daily is “be smart and tough.”
By accepting the reality of this current pullback, you have shown that you’re tough. You’ve earned your stripes by living through previous corrections.
Now is the time to be smart. And that emphatically does not mean abandoning technology stocks entirely.
It means going back to the very cornerstone of my Bauman Letter and Profit Switch investment philosophy: finding companies with real economic prospects and plenty of room to run in their stock prices!
Editor, The Bauman Letter