Top Stocks To Buy When Markets RecoverJun 02, 2022
A Brief Overview of Recoveries
Welcome to the next installment in our in-depth analysis of market cycles.
Because we have defined the recovery phase of the market cycle as a 20% return off the bottom for the S&P 500, there isn’t much point in going through the distribution of total returns over this period.
By definition, it’s always 20%. The real interesting part will be the growth beyond that initial 20%, which we will examine in the future.
But there’s still something to be gained from looking at the length of this period in terms of days and what kind of volatility we can expect to help us contextualize our analysis of sectors.
Length in Days:
Though not quite as short as the post-sell-off bear market, the recovery phase is quite short. Examining data from 1950 through the present, this phase is expected to last about 2 months.
If we look through each market cycle individually, we can see that the recovery phases since 1974 have become increasingly shorter. This creates some urgency for us to act quickly or even preemptively.
Because this is usually a sharp uprise, some investors may want to act sooner rather than later even if things keep sliding.
How rough is the ride?
Because this period is generally quite short with a large gain, we would expect volatility to be quite high. And timing this quick move is near impossible.
That's why as investors if we're getting involved we need to have proper expectations for what's in store. And boy oh boy, having this knowledge ahead of time is more helpful than you realize.
As addressed in the last installment of the Market Cycle Analysis, we can measure volatility by looking at the standard deviation of daily returns. This is the expected change in prices each day over this period.
In the table above, we can see the Recovery phase is the second most volatile phase of the market cycle. However, this kind of volatility is not too frightening as these changes are mostly upward!
While its hard to identify the phase you're in, as you're in it, chances are if you ride this wave its going to feel good.
But this is the market as a whole. So what sectors and stocks in the market are the ones that do even better than the average?
Returns By Sector:
When picking a sector to invest in during a market recovery phase, you really can’t go wrong.
Only one sector has lost money in this part of the market cycle over the last 20 years - Utilities lost around 5% in the 2001 market recovery, but Utilities was also one of the best performing sectors in the 2020 recovery.
So if everything is going up, we are then faced with the paradox of choice. How can we decide where to invest to make sure we maximize our returns over this part of the cycle?
To rank our choices we’re going to be looking at the growth of each sector over this phase of the cycle.
If we look at the expected return over the recovery phase by sector, we can see which sectors perform better. Although the Real Estate sector appears to blow its competitors out of the water, it should be noted that the Real Estate Sector as we know and love it today has only been around for one market cycle.
Therefore, we do not want to rely too heavily on this number for our expectations. This is the same story for the Communications sector.
With this caveat in mind, we can see the Health Care, Financials, and Consumer Discretionary sectors lead the way during the recovery, on average.
The expected laggards are Consumer Staples, Utilities, and Energy. However, these numbers don’t tell the whole story.
When making sector allocation decisions, we also want to look at relative returns. This compares the return of each sector against the return of the S&P 500 over the same period. This helps us make a more direct comparison of returns. For example, the average return of Industrials might be 30% over the last year, but the relative return would be -5% if the S&P 500 returned 35% over that same period. In that case, we would have been better off investing in the broad index or a different sector.
There are a few ways we can make sector allocation decisions based on the data of the relative returns from the last 20 years.
The first and most obvious way is to look at the expected relative return of each sector compared to the S&P 500 (which is the broad market index). Remember that we have defined the recovery phase as the first 20% return after reaching the market bottom. So when we look at relative sector returns we are effectively subtracting 20% from their return over this same period of time.
Looking at the chart above, we can see any sector with positive relative returns is a good bet. The ranking of sectors by relative growth is the same as the non-relative growth, with Health Care, Financials, and Consumer Discretionary leading the way.
But what if we aren’t confident that we’ll see that same order of sectors? What if we invest in Health Care, but then Health Care stocks are the worst-performing this time around?
To protect ourselves from such an adverse outcome, we can look for the Safest Bets, picking the sectors that have the highest returns, even when they’re at the bottom of the pack.
These sectors will help us avoid lagging the market in the recovery too much.
But if markets are ripping upward, why play it safe? If we look through the relative returns, these sectors perform the best during a recovery, historically.
Finally, we can find a Happy Medium based on where sectors rank throughout all recoveries over the last 20 years:
If we consider the opportunity set of sectors across these different dimensions and scenarios, we see Financials and Consumer Discretionary lead the pack with Technology not far behind. An honorable mention must also go to Health Care and Materials.
Keep in mind that all sectors have great buying opportunities in this part of the market cycle. We are looking at groups of stocks here when we analyze sectors. By first analyzing sectors we give ourselves a compass to look for investment opportunities.
For some additional context to our sector analysis, we examine the expected volatility of daily returns in the Recovery phase.
In the chart above, Financials leads the pack, followed by Energy and Technology. Again, we are excluding Real Estate and Communications from this analysis in general because of how new these sectors are.
It is not unexpected that Financials, Technology, and Consumer Discretionary rank among the most volatile during the recovery period as they are also some of the sectors with the highest expected overall return during this phase of the market cycle. In this case, the volatility is not unwelcome.
The reason we want to keep the expected volatility in mind is to prepare ourselves mentally for what is to come. There may be days with 5% jumps in the Financial sector (and much higher for individual names) during this period. It can be exhilarating and frightening to invest during this time, but when we know what to expect we can make better decisions.
As the market shifts from a bear market to a recovery in its market cycle, we want to begin to reallocate our money from the safe havens of Consumer Staples and Utilities, and into sectors with more upward potential, such as Financials and Technology. Health Care investments are a reliable investment through both of these phases, and is one of the least volatile as well.
For our favorite stocks in these sectors, see below.
Favorite Stock In Each Sector:
Before we discuss our top stocks within each sector during this phase of recovery, we want to note that you can also choose to invest in the index itself if you want to take on less risk.
We recommend taking a look at the sector-specific ETFs through SPDR. For example, if you want to invest in the financials sector, then the corresponding ETF would be XLF. If you want to invest in energy then the ETF would be XLE and so on and so forth.
So with that context, lets dive into it 👇
Financials: Our top 3 financial stocks haven't changed here much. As we mentioned last time Ally, Wells Fargo, and State Street are 3 extremely solid names with different levels of risk tolerance. See more on it here. We, therefore, want to reiterate our overweight ratings and believe that they will do well over the next 12 months once we enter the recovery phase. Here's the quick overview on our thesis:
State Street (STT): State Street is a giant in the financial sector and is a must for most of Wall Street. STT is also very sensitive to rising rates. Over a full market cycle, STT stands to benefit greatly.
Ally (ALLY): One of the reasons we still truly like Ally is because their valuation is trading at a discount to the rest of the market. This is happening because Ally has a large exposure to the auto industry -- which is expected to slow down in 2022. But the expected slowdown relative to the wide valuation gap does not account for such a large difference.
Wells Fargo: Wells Fargo is also extremely sensitive to a rise in interest rates. After analyzing this company more in-depth, we see that not only are they sensitive towards this, but they're actually the most sensitive bank in the S&P 500 (except for Silvergate -- which we still like but has a lot more risk associated with it).
Consumer Discretionary: Another sector to choose from is the consumer discretionary sector. There are a lot of names we like here but the highest reward lowest risk picks are:
Formula 1 (FWONK): F1 is on a mission to be one of the most valuable sports brands in the world and they're well on their way to pulling it off. While they're flat on the year, the fact that they're even close to even is a testament to their business. Read more on our entire thesis: here
Home Depot (HD): Home Depot has consistently been one of the most efficient retailers in the world (across multiple consumer sectors) and we do not see that changing any time soon. Even with the drop in stock price, Home Depot is set up to do very well in any sort of recovery period. See more on it: here
Constellation Brands (STZ): We have been long-time investors in STZ because of their growth metrics surrounding EBITDA, sales, margins and overall valuations. Read more on our price target and thesis: here
Technology: Tech is one of our all-time favorite sectors and if you've been following us for a while you know we write it up a ton. But with valuations across the board getting slashed, many companies' stock prices have dropped a lot more than they should have. While some of these companies were burning capital in an effort to fuel growth at all costs, many have been growing responsibly and have been unfairly punished. So while we stand by all of our historical picks, these picks are some of the safest low-risk picks within the tech sector over the next 12 months.
Tesla (TSLA): Tesla has been and continues to be one of our top picks of all time. Elon is innovating at such a rapid pace and Tesla is poised to become the most valuable company in the world over the next decade+. The company has proven it can scale and they also are moved into new verticals. To learn more on how we think they can rise further, just click here
Palo Alto Networks (PANW): Another long-time favorite of Moby, PANW is a cyber security stock that won't stock growing. Even in the face of a potential recession, PANW is showing a HUGE amount of revenue growth and is consistently CRUSHING earnings calls. To read more on it, click here
Microsoft (MSFT): Is it a sleepier pick? Most definitely. But in a period with high volatility, the sleepier picks like Microsoft have the potential to return more with less risk. And it's not just about the medium-tier growth here. Under the surface, a lot has gone right at Microsoft setting them up to accelerate growth this year and into the future. More on it: here