After months of high-correlation, returns are diverging, highlighting the difference between stocks with great fundamentals and everything else

 

***Closed for Thanksgiving

Please note that our offices will be closed on Thursday and Friday so that we can spend time with loved ones. On Thanksgiving, we’ll be taking a day off from the Digest, but we’ll pick back up with it on Friday.

 

***”It’s only when the tide goes out that you learn who has been swimming naked“

That folksy quote comes from investing legend, Warren Buffett … and it’s a suitable description for a dynamic that’s taking place in today’s market.

As you likely remember, late summer/early fall was a fearful time. Investors faced a laundry list of concerns — the inverted yield curve, disappointing U.S. manufacturing data, a slowdown in corporate stock buybacks, poor technicals as stocks had broken key support levels …

Fear was spreading. And in times of fear, investors tend to herd into the same defensive positions. Basically, everyone is running for cover since significant macro concerns overhang the entire market.

Now, compare that to when conditions are more optimistic …

When no massive storm clouds threaten the entire market, investors feel free to turn their focus to the unique situation of each individual stock. Obviously, some stocks will be better positioned for gains than others.

In this type of market, accomplished stock-pickers are able identify the truly excellent investments from the average “ho-hum” investments. Some stocks begin to stand out as superior, and then pull ahead from the pack.

In other words, the tide goes out … and that’s when we see the real condition of the various “swimmers.”

The technical way we measure this difference is through stock return correlation.

A correlation of 1 would mean that stocks are moving together perfectly. A zero correlation would show no relationship at all between stock returns. A correlation of -1 would mean stock movements are perfectly opposite.

 

***After months of trading together, many big U.S. stocks are diverging, and it’s pointing toward one thing — it’s becoming a stock-picker’s market

Throughout November, the average three-month rolling correlation among stocks in the S&P 500 has been falling.

Among individual stocks, correlation dropped to 0.23 last Friday. That’s down from 0.42 on Oct. 30, and below the five-year average of 0.30.

Below, you can see correlation rising during the fear of late summer/early fall, then declining sharply beginning in late October as investors grew more confident.

 

 

This falling correlation makes sense.

In early November, here in the Digest, we wrote how three major “storm clouds” that had been hanging over the market had lifted.

Specifically, uncertainty around what to expect from the Fed and interest rates had dissipated; we had (mostly) made it through earnings season without any major negative surprises; and trade agreement news was largely positive.

As we noted, news on the last point — a trade agreement — can change on a dime. So, while this is still a wildcard issue, at least at the moment there’s still optimism about a deal.

Put all this together, and there aren’t any immediate, ominous clouds herding investors into the same positions today. That means investors feel emboldened to evaluate companies on a case-by-case basis and invest accordingly. So, decreasing correlations are an obvious outcome.

***“Don’t confuse a bull market for brains”

This just-as-folksy quote comes from another investing legend, Louis Navellier.

Earlier this fall, Louis penned a special collection of essays called the “Peak Performance Series.” In it, he tackled the psychology behind investing, shining a spotlight on the most common “behavioral finance” blunders that trip us up and result in poor investment returns.

One of them was self-attribution bias — basically, the tendency to believe that it’s our own expert stock analysis that leads to strong returns from our portfolio … rather than just a bullish market — or, as we just noted, from a high-correlation “all stocks are rising” market.

From Louis:

When a stock we picked goes up, it is because we are clever and made the right choice. When a stock we picked goes down, it is the economy, the Federal Reserve, the stupid broker, or those gosh-darned hedge funds that made things go wrong. We could not have possibly made such a bad choice.

On Louis’ last note, when returns don’t go our way, rather than blame something else, let’s take responsibility. In this case, that means turning our focus to how we’re finding stocks.

What’s your strategy? Are you investing based on a system, or based on tips, hunches, and gut-feel?

Louis learned long ago that most investment strategies that are rooted in subjective factors often don’t hold up well over time. That’s because this subjective quality exposes such a market approach to the biggest investment threat of all … our own emotions.

Fear and greed often lead us to do the exact wrong thing — at the exact wrong time. That’s why Louis went a different direction many years ago with his market approach, turning toward something that isn’t affected by emotion …

Numbers.

From Louis:

I’m a numbers guy. Always have been. Since I was a kid, I’ve loved math and I knew that math was the right way to understand the world.

Said another way, I depend on evidence for my decisions.

I depend on an objective set of criteria that signals what I should buy, when I should buy it, and when I should sell and collect the profits.

 

***A real-time case study of Louis’ market approach

PennyMac Financial Services, Inc. (PFSI), is a direct mortgage lender, helping its customers buy and refinance houses. Since its founding in 2008, PennyMac has grown to become a leading mortgage lender in the U.S., with more than 1.5 million customers. Louis recently recommended this stock to subscribers.

So, what was it about PennyMac that he liked?

I recommended PFSI not because of a cool story I heard on TV about it, but because of the numbers.

You see, I have a proprietary 8-point system that determines if a stock is positioned for outsize gains. It must have strong sales growth, operating margin growth, earnings growth, earnings momentum, earnings surprises, analyst earnings revisions, cash flow and return on equity.

Ultimately, I want the stock’s Total Grade, which are the fundamentals and buying pressure blended together, to be A-rated. This makes it a strong buy. I will not recommend a stock that is rated lower than an A. That is just the case with PFSI, as you see here.

 

Louis recommended PennyMac just a few weeks ago on 11/8. What’s happened since?

As I write Tuesday morning, while the S&P has edged up about 1.6%, PennyMac has popped over 11% as you can see below.

 

 

This is a great illustration of how a stock-picker’s market has a way of separating the great stocks from everything else.

Louis believes plenty more gains are in store for PennyMac, but wait for a pullback before investing. Louis’ buy-up-to price is $33. As I write, it’s trading around $34.36.

***What’s your strategy for picking stocks?

Do you have one?

If not, and you respond to Louis’ numbers-based approach, click here to learn more about how it could make a difference in your portfolio.

Regardless, pay attention to today’s changing market conditions. With many big-picture fears having faded to the background, the focus now is on specific companies.

This means we can expect to see a growing differential between the market returns of fundamentally-strong stocks and all the other “naked swimmers.”

Have a good evening,

Jeff Remsburg