Is it a stock market or a market of stocks?

That philosophical question has a way of stirring up heated debates among analysts.

The former resonates well with investors that prefer to buy and hold the broader market, like through an index fund.

The latter believe that active stock picking can beat the indexing approach.

The truth is that both approaches work, but only under the right conditions.

And so far this year, the stock market is trouncing the market of stocks. That’s because the big players got bigger and pulled the broader indexes to new heights. At the same time, the average stock has underperformed.

But the conditions that supported the stock market are undergoing a major evolution, which is giving way to a new winner.

These Forces Dwarf the Stock Market

Powerful tailwinds that have served the stock market well are now turning against it.

These are forces that dwarf the stock market in size.

One of them is the $47 trillion bond market. I’ve written before about the impact of yields and how falling interest rates juiced stock valuations. That’s particularly true for the “long duration” growth companies whose profits lay well into the future.

Now interest rates are breaking higher, as shown below. That’s putting pressure on stock valuations … especially the more expensive sectors of the market:

(Click here to view larger image.)

Here’s another dominant force that’s flying under the radar.

The strengthening U.S. dollar will put a dent in overseas profits U.S. companies generate. That’s because the more the dollar strengthens, the less international sales are worth in dollar terms. And large-cap stocks, such as those in the S&P 500, get a bigger portion of their revenues from overseas compared to smaller companies:

(Click here to view larger image.)

The chart above shows the relationship between the dollar and the S&P since it peaked on September 1. The market fell 5% as the dollar strengthened.

Time for the Market of Stocks

Earlier this summer, five stocks made up nearly 23% of the S&P 500. They’re the ones driving the market, but they’re also the most susceptible to the external forces I highlighted above.

It’s why several Big Tech stocks — such as Apple, Amazon and Facebook — are now in correction territory this week after dropping more than 10% from their peak. And the stock market is taking a thrashing as a result.

Expect more of the same as we head into the fourth quarter, which is why Ted recently gave you a guide to handle market volatility.

But these evolving conditions also favor the market of stocks, and the opportunities are ripe for stock picking.

Rising interest rates and a steeper yield curve favor value-oriented and cyclical areas of the stock market. A stronger dollar signals a better growth outlook for the U.S. economy, so look to companies that generate a more significant portion of their sales domestically, including mid and small caps.

When I combine those two, one exchange-traded fund, in particular, stands out: the Invesco Dynamic Leisure and Entertainment ETF (NYSE: PEJ). Its portfolio is more concentrated in smaller-cap and value companies … precisely the ones that stand to benefit in this environment.

So don’t let the stock market’s volatility distract you from the opportunities lurking in the market of stocks!

Best regards,

Clint Lee
Research Analyst, The Bauman Letter