We mostly hold a very concentrated portfolio of a few high conviction individual stocks. But we pay enormous amount of attention to the general market and the difference in performance between the major indices. Why so? Based on statistics, 75% of the individual stocks trade in the same direction of the general market.
When you pick a stock in a bull market, you immediately have 25% odds against you that the stock might not be performing with the bull market. When you pick a stock in a bear market, you immediately have 75% odds against you that the stock could be going down with the bear market. To us, the general market is like the weather. When the weather is nice, people are happy and flush with liquidity. People tend to be willing to pay top dollar (high P/E multiples) for stocks. When the weather is not nice, especially during storms, people are busy seeking shelters and would not want to buy stocks, never mind paying top dollars for stocks. That’s why you see valuation expands at market top and contracts at market bottom.
Staying out of harm’s way, preserving your hard earned money is the number one priority when it comes to investing in the stock market. Quite a lot of investors don’t understand the importance of the direction of the general stock market and normally sum it up as that you can’t time the stock market. We beg to differ. There are plenty of clues in the stock market for the seekers to know.
Now we have gotten the general market direction correctly since the 4-year stock market cycle does a good job at forecasting price and time of tops and bottoms. Then why do we bother to buy individual stocks risking 25% odds of getting it wrong in a bull market? The answer lies in the alpha, the alpha that a winning individual stock can provide against the index investing.
Yes, index investing is safe. It doesn’t matter how much it crashes, it will always come back. That can never be said about some individual stocks. Some crashed individual stocks never come back.
When you take risk and do get an outstanding stock that’s capable of making 100-1000% of substantial profits, it would generate outsized alpha in your portfolio that could fundamentally change your financial life. This is one of the main reasons that we tend to focus on a few high conviction stocks that are potentially capable of 10X of profits.
Cyclical stocks are not meant to perform in all conditions, they are only outperforming the general stock market at certain phases of the bull market when the macro conditions are conducive to the cyclical industries. We always bypass the cyclical stocks and focus mainly on growth stocks. Growth stocks are meant to perform in all conditions, they can grow no matter what. The trouble with the growth stocks has always been valuation. Because of their abilities to grow, those growth stocks are always traded in a lofty valuation. They are expensive for a good reason.
Growth stocks tend to be more volatile. When the S&P 500 declines 20-25% in a bear market, many stocks will plummet 60-70%. When the S&P 500 dives 52% in 2008, many stocks fell 80-90%. The growth stocks are two to three times as volatile and risky as the others.
PLTR is a growth stock that fits the pattern. PLTR went public last fall in the midst of the raging growth stock bull market. It tripled in value in 13 weeks after the DPO breakout. PLTR topped in Q1 2021 that was in sync with the general stock market momentum peak in February 2021. PLTR was expensive when it went public, it got really expensive during the meme stock mania in Q1 2021. Now it has corrected 62% from the Q1 top to May low. The final correction low is not in until the general market finishes the sideways trading and makes a bottom sometime in Q4-Q1 2022. Because PLTR has corrected so much in price and time when compared to the pending general market correction, when the market finally turns around, PLTR will be the first to rise out of the bottom and outperforming the general market which will lead to another bull run.
As you can see, after the February 2021 general market momentum top, the general market continues to make new highs and many growth stocks went into bear market (correcting more than 20%). This really proves the point that individual stocks bear market do exist in a general bull market. Everything rally happens in a shorter period just like what happened from March 2020 to February 2021. From February 2021 till now, the market was insulated by the rotation to value/cyclical sectors.
In lieu of dealing with the volatility associated with the growth stocks, there are ways to improve alpha when investing in the index.
- Double down when the market corrects 20-30%, meaning add index positions. The market may correct more than 30% sometimes, but you know it will always come back. So you will have the confidence to go all in.
- Investing a portion of your money in leveraged index funds to have a better return.
Technically, as long as the NASDAQ stays above the 14,200 support level, there will be no meaningful correction. It has been four weeks since the NASDAQ last touched the 14,200 support level.
It has been six months since the market momentum topped in February. This chart really shows the frustration of the bulls and bears equally. Selling a bull market top has always been very challenging.