Don’t fear the reaper … or, at least, we shouldn’t be worried about traders reaping some profits right now. This week’s uptick in market volatility shows all the signs of profit-taking rather than a fundamentally negative shift in the market. Although fluctuations like this can be frustrating for traders with a bullish bias, it looks very routine.
However, in this week’s update, we’ll take a closer look at the selling and where that may create new opportunities.
The first clue that this volatility, which started last Tuesday, is profit-taking rather than a fundamental change in the market is that the hottest sectors and assets are dropping.
At the same time, other groups remain defensive and bullish or neutral.
For example, small-caps that have exceeded most expectations over the last 12 months lost more than twice what the S&P 500 had lost by Tuesday morning.
Extremely speculative assets like Bitcoin (CCC:BTC-USD) (see the following chart), solar stocks, development-stage biotech and hot stocks like Tesla (NASDAQ:TSLA) performed especially poorly over the last few days, which is completely normal after the run those assets had over the previous 12 months.
Our argument in favor of higher prices in the market focuses on the following factors:
Easy Monetary Policy from the Fed
As you can see in the following chart, long-term interest rates have been rising recently, but the Federal Reserve remains committed to its bond-buying program that should keep borrowing costs low.
Federal Reserve Chair Jerome Powell told the Senate banking committee on Tuesday that “it is likely to take some time for substantial further progress to be achieved” for the economy to reach long-term growth and inflation targets.
We feel that Powell’s comments came at the perfect time on Tuesday and were the primary factor that reversed the broad indexes and tech sector losses.
The Fed’s program can’t last forever, but we don’t think a change is likely in the short term. For now, we don’t plan to recommend any changes to our strategy until the 10-year Treasury yield gets to 2%.
Stimulus Spending Should Support Short-Term Demand
We know that the fight to increase the minimum wage has overshadowed much of the news about the stimulus.
In our view, if the fight in Congress is about an aspect of the stimulus bill (minimum wage) rather than the bill itself, then the likelihood for direct payments this quarter is a near certainty.
We aren’t the only investors who feel that stimulus is likely to happen quickly. Selling the news of more direct payments could be one of the triggers for the recent volatility, but we think that is a temporary issue and will reverse shortly.
The selling has hit several retail stocks hard. A selloff is always frustrating, but it’s also why we focus on stocks like this that are most likely to bounce back when traders look to buy into the dips.
We think there are likely to be more opportunities for us in the retail sector soon. For example, housing-related stocks have been oversold and could be an interesting place to look for new profits.
As you can see in the chart above, the SPDR Homebuilders ETF (NYSEARCA:XHB) is already coming up off its lows. A confirmed breakout in housing could trigger a new entry opportunity. We’ll keep you posted.
This earnings season has been very encouraging. So far, profits are up roughly 3% among the S&P 500 on a year over year basis.
This comparison shows that the first quarter of 2021 is doing better than the first quarter of 2020, which was mostly before pandemic hit spending numbers.
To put things in perspective, on a year over year basis, profits declined more than 9% in the fourth quarter of 2020.
However, there is an important caveat for this factor: Earnings are much lower than in 2019, and stock prices are a lot higher.
This doesn’t mean stocks will fall, but it does increase the likelihood that volatility will remain high.
What if the Selling Continues?
Over the last two years, corrections (excluding the pandemic crash in March 2020) have lasted an average of 27 calendar days. The vast majority of corrections last between 18-24 days, so we may not be done with this round yet.
Therefore, we focus on stocks that have stronger realized performance than the average in the market and their groups.
Specifically, we have found that factors like the number of days it takes for a company to turn its expenditures into revenue, trailing cash flow trends and leverage ratios have the most predictive impact on stock performance during a period of volatility.
We focus on this kind of analysis because it allows us (when necessary) to take possession of stocks at a lower price when the market corrects and sell more option premium against those positions until the market rallies again.
For example, during the last extended period of volatility (Sept. 2 – Oct. 30, 2020), while the S&P 500 lost 7%, we brought in an average positive return of 5.9% per trade.
While any good plan should remain tentative as new information is received, we don’t plan to modify a strategy that has been working so well.
The Bottom Line on Volatility
Earnings season is winding down, and the stimulus bills seems to be steadily working its way through congress. We don’t see any short-term issues that would spoil the current market.
However, the volatility may not be over yet. We tend to reduce our trading frequency a little during periods like this, so we don’t add too much exposure to the market when prices are dropping.
While there is some potential for a quick reversal, we will wait until the market makes the turn before modifying our strategy.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.