Market momentum is Red. Today, the market rolled over once again… and the Bull Trap, dead cat bounce, or bear market rally (pick your favorite term) is starting to fade. There are two primary reasons for this selloff that I’ll explain.
I just turned on the news, and the Dow sold off nearly 500 points. I’m not surprised by this bear market. Instead, I’ve been cooking meatloaf since momentum went negative this afternoon on Utilities and Real Estate. I took some gains off the table today, and now I’m looking for a selloff over the next 24 hours to continue. I’m really looking forward to dinner.
We – now – only have healthcare propping up this market, and most traders are taking profits. The SPDR S&P Biotech ETF (XBI) slumped 3.5% today. The financial media is putting the blame in two places for the market’s rolling over…
First, the consumer confidence index slumped to 98.7. That number is down from 103.2 in May and fell short of consensus estimates of 100, according to The Conference Board. A drop in consumer confidence continues to accelerate as Americans confront inflation, supply chain shocks, and more.
Then, there’s just the general view that the U.S. economy is heading into a recession. That shouldn’t be much of a surprise. As I’ve noted, we know that market momentum is strong to the downside because of the number of equities that hit 52-week lows. Today, we had 193 stocks hit new annual lows compared to just 37 at new highs. Despite this recent bear market rally, that trend of more stocks moving lower has remained constant.
But I can give you a much better understanding of what happened today, ad a quick lesson on where to park some money.
The Fed at Fault for Bear Market
The central bank is largely responsible for all direction in the 2022 market, particularly as we continue a period of valuation compression and price discovery.
It’s hard to argue otherwise. The focus on inflation numbers over the last five months combined with the Fed’s reaction with rate hikes has fueled the up-and-down movement and volatility. The higher rates go, the more pressure we’ll see on balance sheets and valuations.
In addition, history shows that when the Fed reduces its balance sheet, the market can experience volatility. This pattern persisted in 2018 when the central bank sold bonds back into the market.
It just so happens that the Fed promised to sell $47.5 billion in bonds and mortgage backed securities in June. So far this month, it hasn’t sold any. We await to see the Fed’s plan tomorrow, as the central bank typically engages in these operations on Wednesdays. Tomorrow is the final Wednesday of the month.
Meanwhile, investors are keeping a close eye on the PCE Inflation report released this Thursday. This inflation report is the Fed’s preferred measurement of prices. Based on this reading, the Fed will likely set its policy position on interest rates for its July meeting. If the number is under the expected figure, it may only increase rates by 50 or 75 basis points.
But if it lands above the target, a high print would suggest that the Fed must be even more aggressive in higher rates. Simply put – traders are taking gains after a nice six-day run for the S&P 500, Russell 2000, and in sectors like Utilities, Real Estate, and Energy. Profit-taking is a must in this environment of negative momentum.
Now, Let’s Go Long
Cash is your best friend right now. I always say this. But so too… is cash flow. As we sit in a market dominated by the Fed and speculation around interest rates, there’s a good reason to consider buying a few stocks now.
In this environment, it’s best to avoid stocks with very pricey valuations. I’m talking about stocks that trade at very high price-to-revenue (Price/Sales) that define “growth stocks.” If interest rates go higher, they are likely to suffer more problems ahead.
Instead, you can be defensive. One of the best ways to do this is to focus on companies that have strong free-cash-flow. In this situation, I’m not going to speculate on some tech stock that might disrupt “hydration” or “handshakes” – two things that have been pitched to me in the last two months…
I’m going to focus on stocks that pay me cold hard cash. In times of uncertainty, I want to be able to pull money out of these companies and stuff them under the mattress. So, let’s look at stocks that trade at low enterprise value to free cash flow.
We take the total value of the company and measure it against future cash flow. What I’ll do here is look for companies that trade at very low multiples and have improved their balance sheet over the last year. I’m combining the F-score of 9 with an EV/FCF under 8.
It’s not surprising that companies with rock solid balance sheets that trade at cheap cash flow numbers comprise sectors like metals, energy, and healthcare.
- Dow Inc. (DOW) has a 9 F-score and trades at at 7.76x EV/FCF
- Freeport-McMoRan (FCX) has a 9 F-score and trades at 7.89x EV/FCF.
- CF Industries (CF) has a 9 F-score and trades at 6.07x EV/FCF.
All three companies have pulled back during this crisis. But the cash flow is cheap and the balance sheets are strong. These are the types of stocks that you want to start building a position in over time. We’ll talk about how to position size in a bear market on Wednesday.