As Investors Wait for Capitulation, Here's What Could Trigger a Reversal

Be ready. An ugly liquidation stage to key S&P 500 levels will put the stock market well in front of the Fed, leading to a buying opportunity.


Stocks quotes in this article:

AAPL

Markets that resemble the current one have the feel of approaching an ugly liquidation stage. Powerful but quickly failed rallies give the market a hopeless feel, headed-for-a-lower-level slant. Some growth tech funds and bond funds are down unfathomable amounts, which leads to capital preservation selling, deleveraging, and redemption selling.

meanwhile, a decades-long bull market in bonds has left investors complacently holding fixed-income funds, unprepared for this year’s steep losses as interest rates soar. For a seemingly conservative investment, the principle is down over 10%.

On the other side of the investment spectrum, tech growth managers seem to have ignored valuation on the way up, and are left holding shares that have declined sharply but still offer no compelling value.

Many former darling tech-related stocks have business models that have been exposed as deeply flawed. Fundamentals such as free cash flow were ignored for numerous companies, replaced with the doctrine of growth at any cost. As growth slows, these businesses that were unable to turn a profit in the best of times, look vulnerable to failure when market conditions become difficult and capital harder to raise. These stocks ought to be avoided entirely.

This is a good moment to have a shopping list prepared and dry powder to deploy if the stock market capitulates in a wave of panic selling. This is not to say panic selling is imminent or definitively will occur, but preparing ahead for the possibility is essential. The bargains will be attractive but fear of even lower levels can easily cause capital to stay undeployed — missing a massive buying opportunity.

A good shopping list will feature companies that earn copious cash flow. Additionally, a large buyback plan can be constructive. I recently wrote a column here on Apple (AAPL) as a go-to on weakness; it’s at the top of my list for these two reasons.

Some investors get caught up in buying a stock with relative strength in a severe decline, but this can sometimes backfire. When funds unwind long positions, they often cover short positions as well. The short-covering can make a stock’s strength stand out amid market carnage, yet it’s the sort of buying investors wouldn’t want to tag along with.

Find the quality stocks that funds are liquidating for non-fundamental reasons.

Focus on the Trigger

Recent stock market weakness correlates with the weakness in the bond market, forcing interest rates higher. A further spike in rates can easily cause an additional decline in stocks. In a panic-selling capitulation, a turn up in the bond market and an easing of rates, potentially from a flight to quality or severely oversold conditions, can trigger a stock reversal off the lows. Also, the inflation caused by high commodity prices, especially energy, would be soothed if they declined from elevated levels.

Financial conditions are indeed tightening, and the stock market is responding to the aggressive Fed action with notable weakness. However, an abrupt liquidation to key levels on the S&P 500, in the 3800-to-3850 range, will put the stock market well in front of the Fed, leading to a buying opportunity.

There is no certainty as to the direction or character of the markets. In the past, multiple failed attempts at a rally often led to a capitulatory conclusion to the selling, which creates huge bargains. It’s an event to be prepared for with dry powder to be deployed and a shopping list of quality stocks on sale.

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William Murphy

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