Corrections Are Not So Tough If You Know How to Find Good Buys
Here are two basic approaches to buying stocks when the market is struggling.
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Market corrections are inevitable. It is the nature of all markets to go through cycles of ups and downs. The best investors embrace this inevitability rather than fear it. Corrections purge the market of its excesses and create a new crop of opportunities for astute traders.
There are two basic ways to find new opportunities in a poor market. The most common is to look for mispricing. Most market corrections are driven from the top down, and stocks are sold without any regard for their individual merits. Corrections are driven by the selling of indexes and index exchange-traded funds. When an index ETF is sold, every stock in that ETF is sold as well. It doesn’t matter if they are great companies with compelling valuations.
When an index ETF is sold during a correction, every stock in that ETF is sold as well. It doesn’t matter if they are great companies with compelling valuations.
Broad selling during corrections creates substantial mispricing in individual stocks. Eventually, when the corrective action driven by index selling comes to an end, investors will sift through the carnage and start looking for the best values in the trash pile. As more and more investors start to recognize the mispricing, the technical action improves, and there can be some exceptionally good entry points.
Buying broken stocks in a correction is more about fundamentals and valuation than the price action. Investors have to do some hard work to determine if a stock is really just mispriced or whether there has been some significant change in its business. Too often, investors will buy these stocks prematurely and suffer large losses when they fail to recover.
The second approach to picking stocks during a market correction is to focus on relative strength. The logic is that the stocks that are holding up best when the broad market is declining possess some special attributes that suggest that they will continue to perform well when the corrective action ends.
Relative strength can be calculated. It measures how a stock acts compared to all the other stocks in the market. Different time frames can be used, and some calculations use price weighting, giving more weight to recent action, but overall, it is simply a way to identify stocks that are the strongest in the market.
The logic behind relative strength is that stocks don’t immediately discount good news. The academic theory that stocks are efficiently priced and tend to reflect all news very quickly simply doesn’t work very well. In reality, the good news is priced in incrementally. For example, analysts generally increase earnings estimates and price targets gradually. They will be conservative as they raise their numbers and then eventually will raise them more as the stock acts positively.
Another reason that buying high relative strength works is that the psychology of strong stocks attracts buyers who don’t want to miss out. People hate to miss out on the hot action. They want to be in the "best stocks," which are defined as those that are going up the fastest. Relative strength tends to lead to FOMO — fear of missing out.
One of the ironies of relative strength is that the more people chase relative strength, the more it works. Strong stocks feed on themselves as they attract more and more interest. Market players want to be where the action is, and that is in the stocks that are, on average, stronger than the average stock.
Some of the old timers on Wall Street are offended by those who focus on relative strength. It ignores valuation, and quite often, the moves are totally unjustified on a fundamental basis. In some cases, this skepticism makes relative strength work even better as the shorts are squeezed, and hesitant chasers are sucked in.
The key to applying this approach is cultivating the right mindset. You can’t be afraid to buy stocks that have gone up quite a bit already and may be trading at the highs.
The list of new highs is a good starting point, while fundamentals are a secondary consideration. The biggest stumbling block for many is that they focus too hard on trying to establish a valuation argument. This is understandable because, in many cases, the movement is little more than new buyers buying simply because they expect even more buyers to emerge.
In poor markets, stocks with relative strength stick out even more as traders gravitate toward a smaller number of attractive names. Focusing on these stocks can be a particularly good way to identify hot themes such as quantum computing or precious metals.
Market corrections are always difficult to deal with, but they should be viewed with optimism for the many great opportunities that they will create.
At the time of publication, DePorre had no position in any security mentioned.
