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The market has been resilient this month. The major stock market indexes have shaken off an overabundance of bad news. Inflation remains near 40-year highs, borrowing costs are increasing, and companies are ditching hiring plans. Yet, every major market index recovered its 50-day moving average this week, a key intermediate-term trendline.

The wall of worry is steep, but the boat has tilted so heavily toward bears that short sellers are starting to pocket profits, and some risk takers have begun bargain shopping.

The tide may be turning

Today, Top Stocks’ Helene Meisler shared a chart on Twitter showing that the 50 most heavily shorted stocks in the U.S. have rallied 20% since the S&P 500’s low on June 17. The S&P itself is up about 8%. On Wednesday, those stocks soared 3.7% while the S&P 500 gained just 0.59%, prompting Meisler to quote Bob Prechter of Elliot Wave fame, “all rallies begin with short covering.”

The fact that rallies begin with short covering rather than institutional buyers is why the S&P 500 has historically produced its best gains on low rather than high volume. The combination of a market willing to look past lousy news and extreme pessimism is encouraging, but we’re not out of the woods yet. We’ve had significant rallies every month this year, and each has failed.

Nevertheless, the NASDAQ – the most beaten down index since November – has seen fewer new lows and better up volume to total volume, and active investors are increasingly buying weakness in technology stocks. For example, Netflix  (NFLX)  is up since it disclosed it lost nearly one million subscribers; Apple  (AAPL)  and Microsoft  (MSFT)  are up since announcing they’re slowing hiring, and Tesla  (TSLA)  is up despite reporting disappointing deliveries and auto operating margins.

Time to buy weakness?

In his Real Money Pro diary, Doug Kass writes, “The markets are now overbought (see S &P oscillator). That said, I don't see the downside that bears see. In fact, I only see a couple of percent of downside. That is the way I see it, and I am a buyer on weakness, waiting for the right pitch [emphasis mine].”

I explained here and here why Kass’s contrarian with a calculator approach shifted him net long months ago. He took some of that long exposure off this week, “In the last 24 hours, I have taken my foot off of the accelerator a bit - by selling out a few longs - and reducing my (SPY) long position.” However, he remains more bullish than bearish, and he plans to opportunistically use down days to leg back into stocks.

Kass isn’t alone in taking advantage of indiscriminate selling lately.

Real Money Pro’s Paul Price has highlighted stocks trading at historically low price-to-earnings multiples for months. 

He recently shared six lessons from prior bear markets in “On Wall St., Feeling Crummy Is Contagious. Here's How to Climb Back Up” explaining why it pays to become bullish when everybody is bearish. Here are the six lessons, followed by my thoughts;

  • By the time you "can't take it anymore," it's almost always too late to sell.

When you get that “no mas” feeling in your gut, and you’re hovering over the sell button to make the pain stop (famed behavioral psychologist Richard Thaler notes in his book Misbehaving that pain hurts – physically- twice as much as pleasure), remember everybody else IS DOING the same thing. Ask yourself, “In one year will I regret selling, after a steep drop, when everybody else is also selling?”

  • The best bargains only become available when most investors/traders have become very, very scared of further losses. It's then that they'll give up great shares just to ease their pain by lightening up or exiting equities completely.

The pressure on institutional investors to outperform is huge. With redemption letters stacking up on desks this year, their ‘need’ to sell creates an opportunity to buy good stocks on sale. So, when everybody else screams, “get me out at any price,” use that moment as a chance to buy great stocks off the discount rack.

  • Bottoms form in the absence of good news. Trees do not grow to the sky. Stocks only go down so much before they become too cheap to keep falling.

Stocks don't go up or down in a straight line. So, when the distance to long-term support or resistance, such as the 200-DMA, reaches an extreme, recognizing mean reversion is more likely than not.

  • If you wait for positive momentum or improving economic news, you will have missed the easiest and largest percentage gains.

The economy is acting horribly, but stocks are a leading indicator. Historically, stocks bottom before a recession ends, producing their most significant gains when earnings are at their cycle lows. Sure, stocks fall when few believe a recession will happen. However, they tend to rally when everybody accepts a weak economy is guaranteed.

  • There has never been a bear market that didn't resolve itself on the way to new all-time highs.

The S&P 500 has had plenty of gut-wrenching periods in the past, but, eventually, each bear market has built a foundation for a bull market and new highs. 

S&P-500-Chart-042722
  • Over the past 15 years, rebounds happened faster and sharper than most media talking heads and analysts thought possible. Who would have believed how quickly stocks recovered from the dire situation in the spring of 2020?

The first year of a bull market is its best year for returns. According to long-time stock market researcher Sam Stovall, the average first-year return of a bull market is 38%, trouncing the historical 6% compound annual growth rate for the index (rolling 10-year CAGR).

The Smart Play

Some think that market exposure should be “all-in” or “all-out.” However, I’ve found that approach leaves you flat-footed at market inflection points. After all, our biases can make seeing and acting on the market turns challenging.

A better approach is to create a forward-looking framework for your net long or net short exposure and then, tilting your exposure and risk based on that framework,

For example, as a bear is developing (late ‘21, early ‘22), you may conclude rising inflation will spark rate hikes that decelerate economic activity, causing company revenue and profits to miss forecasts unexpectedly. In that scenario, your framework tilts you toward selling rallies and embracing de-risking strategies (diversification, shortened time horizons, lower beta, hedging, etc).

However, when a bear matures (late ‘22, early ‘23), your framework may shift to conclude that decelerating economic activity will prompt monetary and fiscal stimulus (i.e. a friendly Fed and Congress). In this scenario, your framework tilts you toward buying sell-offs and embracing risk-on strategies (concentration, longer time horizons, higher beta, less hedging, etc.).

This framework approach can minimize drawdown during the first half of a bear market when the bulk of the damage is done and maximize returns exiting a bear market when the best returns occur.

So, what’s my framework? I believe front-end loaded rate hikes are slowing GDP, resulting in a recession (we may already be in one based on GDP) that will force the Fed to turn dovish (at a minimum, holding rates steady) within the next year. As time passes, the impact of higher rates fades (Martin Zweig rolled off the negative impact of a rate hike after six months), and comparisons ease, providing a better path for revenue and earnings growth to re-exert.

As a result, I believe next year will be a good year for stocks. Coincidentally, that thinking aligns with the fact that pre-Election years are historically the best performing years in the Presidential cycle (the second best is the election year itself), according to the Stock Trader's Almanac.

Interestingly, this historical path traveled by the S&P 500 in mid-term Election years since 1950 (page 44 of this year's Almanac) shows a bottom in mid-June, followed by a choppy but upward trajectory until late September or early October, and then acceleration into year's end. Of course, history doesn't repeat, but it often rhymes.

Therefore, while I acknowledge seasonal weakness (summer doldrums) and ongoing bad news could cause another sell-off this summer (we could even undercut the prior low one more time), I believe using weakness to cover shorts, rebuild long-term positions, and increase exposure to early-stage stocks (discretionary and technology, primarily) should pay off handsomely.

If you’re a long-term investor, my advice is unchanged. A bear market is the best time to increase monthly contributions via dollar-cost average programs, such as workplace retirement accounts. If you haven’t yet, contact HR to boost your contribution rate (ideally, to 10-15%). If you can’t afford to contribute that much each paycheck, ask if there’s an auto-escalation feature that can systematically increase your contribution over time. If so, increase your rate as much as possible to eventually reach that target.

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