Welcome back to Bauman Daily! I hope you had a safe and enjoyable Memorial Day weekend.

In yesterday’s Your Money Matters video, Clint Lee and I took a hard look at the composition of the recent stock market rebound … and it’s not a pretty picture.

Our first conclusion was that the rally off March lows is entirely driven by mega-cap technology and pharmaceutical companies.

Right now, the top five firms — 1% of the index — comprise 20% of the market capitalization of the S&P 500 Index.

By contrast, the rest of the stock market continues to stagnate.

In the following chart, the blue area represents the S&P 500 Index on a capitalization-weighted basis, where the biggest firms contribute more to the index value. The red line represents an equal-weighted version of the S&P 500 Index, where all firms are represented equally:

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The divergence between the two is the greatest it’s been in the last decade.

In other words, this rebound isn’t broad-based. That means it’s unsustainable.

Eventually even the top tech firms will reach valuations that will make investors shy.

At that point, the big tech stocks will begin to trade sideways and the rest of the market will drag the overall index down.

But there’s a silver lining in this for smart investors … and I’ll explain it today.

Time for a Course Change

In the long term, one way to make money in the stock market is to buy what everybody else is selling. But it’s critical to buy at the right time … and that time is now.

That brings us to the second conclusion Clint and I reached in yesterday’s video.

There’s been a dramatic shift in fund flows away from investments in broad sector indexes — like the SPDR S&P 500 ETF Trust (NYSE: SPY) — and toward sector-specific investments.

For example, over the last four weeks, an exchange-traded fund (ETF) tracking the building and construction sector has broken away from the S&P 500 Index, outperforming it by more than 10%:

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Fund managers all over the world see the same thing Clint and I do: the time to make money by riding along with the market is at an end.

It’s time for a different strategy.

The Going Gets Tough

You’ve probably seen articles talking about the upsurge in passive investing over the last decade.

“Passive” investing means putting your money into ETFs and other investments that cover groups of stocks. Instead of trying to figure out which companies will provide the best returns in an index or sector, you invest in all of them and go along for the ride.

This passive strategy became popular because no matter where you put your money, you were likely to see gains. Practically every portion of the stock market was growing in value.

Not anymore. To make money nowadays, you need to do your homework. The chart I showed you above proves it.

Imagine the stock market as a squadron of jets.

A few of them have powerful engines and can climb faster than the others. But all of them have a maximum altitude. They can’t fly higher than that because there isn’t enough oxygen to fuel their engines.

In the recent rebound, a few powerful firms have managed to get close to the maximum altitude. It’s been a great ride. But their future possible gains are diminishing.

Meanwhile, dozens of other firms are still climbing. They have a long way to go before they reach that limit.

But our airborne stocks are flying into combat. The COVID-19 crisis is like a flak battery pummeling the economy. Some of the stocks still climbing will get hit and crash, like JCPenney, Neiman Marcus and others that have declared bankruptcy.

The trick to profits, then, is to identify the stocks still climbing that have the best pilots … The ones that can avoid COVID-19 flak.

Three Ways to Reach the Skies

The stock market as we’ve known it is dead.

No longer can we prosper by going along for the ride. To uncover gains in this market, you need to find the companies that have the best chance of making it through the flak.

To do that, I start with three principles.

  • First, I look for essential sectors that will survive no matter what. Society can do without retail clothing stores, but it can’t exist without places to live. That’s why I like housing over retail (for example).
  • Second, flying through the flak thrown up by COVID-19 is an enormous drain on fuel. Companies trying to maneuver through lockdowns, workforce disruptions, transportation issues and other challenges must spend extra cash just to do their normal business. So I look for companies that have extra fuel, in the form of strong balance sheets, with plenty of cash and low debt.
  • Third, even among those that meet the first two criteria, some are better managed than others. This is why looking at past performance is so important. All things equal, the company that has achieved faster earnings growth and higher profit margins is the one to pick over its competitors. It’s going to reach its peak value faster than the others.

During the long bull market after the financial crisis, it was possible to do reasonably well in the stock market without a helping hand.

Those days are over. The helping hand you need is right here … in The Bauman Letter.

Kind regards,

Ted Bauman Signature

Ted Bauman

Editor, The Bauman Letter