11/26/2022

November 27, 2022 Newsletter – Be Judicious

Today, we will begin by recapping where the market stands today, which still shows ongoing volatility.

The truth is that it’s a new environment for stocks, and you need a new playbook for a rapidly evolving market.

Let’s dig in.

Big gains?

Since the start of this year, the Federal Reserve has been raising interest rates to try to get a handle on inflation. After all, the U.S. Bureau of Labor Statistics’ Consumer Price Index (CPI) hit a four-decade high of 9.1% in June.

Rampant high inflation is destroying the disposable income of households and businesses.

So, the U.S. central bank is trying to slow inflation growth and bring on price stability. That way, consumers and companies can better understand what their incomes will look like… and then they can better budget their money.

The Fed has said it needs to kill economic demand to get inflation back under control. Its best tool for doing that is raising interest rates. However, that means it costs more to borrow in the economy… making the dollar more valuable.

As a result, higher interest rates pull money out of the financial system because the dollar’s value rises and investors want to pour more money into the safety of higher-yielding U.S. Treasury bonds.

So what’s going to happen next? Will the Fed pivot?

As inflation comes down while rates rise, the Fed will be poised to stop raising rates in the next 6, 9, or 12 months.

Nobody knows for sure, but when it does happen, it is likely that stocks will be poised for significant gains.

We’ll be keeping an eye on this for you…

Throw out the old rules

Whether you realize it or not, we’re in a new market environment. That means you shouldn’t trade using the old playbook.

Specifically, some major sectors are rising while others – ones that are more sensitive to higher interest rates, inflation, and recession risk – are falling. Some individual stocks are down 80% or 90% over the past year, while others have seen relatively smaller pullbacks.

The truth is…some stocks are doing great…while others are losing most of their value.

There’s been a major personality shift in the markets, so it’s important to be extremely selective about which stocks you buy..

Let’s look at the major S&P 500 Index sectors since the start of this quarter, just before the U.S. benchmark’s most recent low on October 13…

Over the past seven weeks, there have been a lot of winners, some much more than others. “Real economy” sectors, like energy, industrials, and materials businesses are up 30%, 21%, and 20%, respectively, since the start of October.

If this is the start of a new bullish personality for the markets, boring old names could be the leaders moving forward…

Conversely, the consumer discretionary sector is down almost 2%, while consumer staples –led by conservative names like Procter & Gamble (PG), PepsiCo (PEP), and Coca-Cola (KO) – are up 13% over the same time period. Plus, utilities – which had been a market leader for a lot of this year – are lagging, up only 6%.

Aside from the strength of energy stocks, this is different from what we’ve seen for most of 2022. You might remember that during the bear market rallies, the tech darlings of the past decade were among the big winners, and it didn’t quite make a lot of sense to us…

Now it seems new rules are in effect…

The leading consumer staples stocks – as measured by the Consumer Staples Select Sector SPDR Fund (XLP) – are outperforming their discretionary-sector leading peers like Nike (NKE) and McDonald’s (MCD)…

In other words, the market winds are shifting, and it would be wise to pay attention.

This may call for bullish bets on some sectors while also at the same time making bearish bets on others…

So what are you supposed to do?

Some portfolio building tips

Discretion and judgment are key under these market conditions.

To maximize your returns, you must construct an optimized portfolio.

Generally, the rule we follow is that you should only allocate 4% to 5% of our portfolio to any one position. Make sure that your investments are diversified, and no single investment makes up a large part of your portfolio.

To determine which stock holdings to reduce, there are certain metrics you need to be analyzing at all times.

First, review the price-to-earnings ratio (P/E), which is the ratio of the stock’s share price to the earnings per share (EPS). A lower P/E generally indicates that the price to purchase the stock’s earnings is inexpensive, and a higher P/E indicates that you may be paying a premium for the stock’s earnings. In other words, a low P/E means the stock is cheap, and a high P/E means the stock is expensive. However, make sure that you compare a stock’s P/E with the market average and especially with its competitors.

Next review the price-to-book (P/B) ratio, which is the stock’s share price divided by the book value per share. Book value is determined by subtracting the total liabilities from the total assets. By dividing the book value by the number of outstanding shares, you obtain the book value per share. Dividing the share price by the book value per share gives you the P/B ratio, which measures the market’s valuation of a company relative to its book value. In other words, it’s a way of determining whether the market is underpricing a security.

The third metric to pay attention to is the price-to-cash-flow ratio. That’s a stock’s share price divided by its cash flow per share. Cash flow is a measure of profitability that eliminates a lot of the assumptions that make up earnings. It measures the real dollars hitting the company’s bank account.

When you check your stocks against these three ratios, you can see which ones are overvalued and may need to be pruned. They’re even a good place to start when you’re first looking at what stocks to buy next.

These metrics are a simple yet powerful tool that anyone can use without going through hours of research on every stock.

Let us do the hard work for you

We are hard at work uncovering the next big stock plays for you, which we believe, based on our research, will be poised for significant moves.

We will return later this week with more information.

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