The Stocks to Own for a Correction

How good was the tennis last night?

Nick Kyrgios might not be everyone’s cup of tea (Australian’s don’t like their sports personalities having too much personality) but he produced one of his best performances last night, while going down to a brilliant Grigor Dimitrov.

The Aussie Open is setting up for a repeat of last year. Dimitrov is on track to meet Rafa in the semis. Last year they fought an epic five-set match. And old King Roger has barely been troubled.

Rog and Raf to meet again? Surely not…

Stranger things have happened, though. Like the Dow Jones Industrials or the S&P 500 continuing to defy gravity.

Being a Monday, the Aussie market is set to open higher thanks to another record close in the US on Friday. The upward march of stock prices is relentless.

Still, at times like these, when everything feels good, it helps to have some perspective.

For example, most people probably think of the market as having had a good run, but not being overly risky. It’s akin to looking at a chart like the one below. That is, positive, but unremarkable.

Dow Jones Industrial Average DJI Daily Chart | 22-01-2018

Source: Optuma
[Click to enlarge]

That’s a short term chart. It shows the Dow Jones Industrials index only over the past six months.

But if you zoom out considerably to get some perspective, the picture changes.

In fact, it changes dramatically.

The chart below shows a much longer term time frame.

Dow Jones Industrial Average DJI Daily Chart | 22-01-2018

Source: Optuma
[Click to enlarge]

It puts the recent run up into perspective. That is, since Trump’s election in November 2016, the Dow Jones index has soared 46%.

That’s a 46% gain in a little less than 15 months.

For some perspective, the Dow gained 45.6% from the lows of 2004 to the October 2007 peak. So pretty much the same gain in 36 months.

Now, how do you feel about the market’s recent run?

I’m nervous too.

But I want to be clear on one point. I don’t think you’re about to see a 2007 style meltdown. While I could be wrong (and am always ready to admit it and change tack) I don’t see the same excesses taking place.

For example, the global banking system is in much better shape than it was in 2007. The impaired global banking system was a major reason why the flow of credit dried up so quickly. I don’t see that happening this time around. 

Market correction looming

But clearly, there is way too much exuberance. US stocks have gone parabolic. This increases the probability that you’re going to see a decent shake out take place…sooner rather than later.

In my view, there is a high probability that you’ll see a 15–20% correction in the US stock market play out in the next few months. Rapid advances like the one you’ve seen over the past year are very rare.

They just don’t happen without the market giving up some of the gains.

I’m not sure what this means exactly for the Aussie market. As you can see in the chart below, the local index hasn’t done anywhere near as well as the US market.

From the Trump election low to the recent peak, the ASX 200 has ‘only’ advanced 19%. That’s pretty good, but it’s less than half the rally experienced by US stocks.

S&P / ASX 200 XJO Daily Chart AUD | 22-01-2018

Source: Optuma
[Click to enlarge]

Therefore, it makes sense to expect the Aussie market to be relatively resilient in the event of a correction in US stocks.

Unless, that is, the sell-off is China related. All decent corrections need a catalyst of some kind. Who knows what the catalyst will be to spark the next correction?

But if it has anything to do with China, commodities will cop the brunt of it. That means Aussie stocks won’t be as insulated as we’d like.

The most prudent thing to do in such an environment is to either increase cash holdings (assuming you’re fully invested) or add stocks to your portfolio that have underperformed the market and offer good value relative to the market.

But don’t just buy underperformers for the sake of it. Some stocks are weak and cheap because they are simply poor quality. There needs to be a clear reason why the stock hasn’t done as well as the market, and a clear reason why it should perform better in the future.

During a correction, sentiment changes. Money flows out of what’s hot and looks for ‘relative value’. This is why previously unloved stocks tend to perform better in a correction.

So having a few of these type of stocks in your portfolio wouldn’t be such a bad thing right now. Especially given the vertiginous rise in the Dow Jones I showed you earlier.

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia