Our investment experts hail from diverse locations, backgrounds and experiences. They’re smart, opinionated and highly educated. But they have more to offer than “book smarts.” They’re also seasoned investors with considerable life experience.

My colleague Jim Pearce is one such expert. Jim is the chief investment strategist of our flagship publication Personal Finance and its ancillary advisory PF Pro. He also helms our premium trading service, Mayhem Trader.

Let’s take a break from the stock market’s daily gyrations to take a deep dive with Jim into his money-making methodologies. The article below is a condensed transcript; for additional details and charts, watch the video.

First, a few words about Jim Pearce.

Jim began his career as a stockbroker in 1983 and over the years has managed client investment portfolios for major banks, brokerage firms and investment advisors. Jim earned a BA from The College of William & Mary and the CFP designation from the College of Financial Planning.

We’ve been enjoying a robust stock market rally so far this year, but risk and uncertainty abound. The key to mastering risk resides in what Jim calls “Mayhem Trades.”

As the guiding force behind Mayhem Trader, Jim has developed a strategy to flip market mayhem into fast payouts.

I asked Jim how his Mayhem Trades work, as well as several questions about the direction of the economy and markets in the second half of 2023. My questions are in bold.

The stock market has been rallying lately, but what risks do you see over the near term that the investment herd is underestimating?

Although inflation is slowing down, the full impact of accommodative monetary policy during the coronavirus pandemic is far from over.

The situation with M2 is revealing. M2 is the Federal Reserve’s estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and short-term saving vehicles such as certificates of deposit.

The amount of money in the U.S. as measured by M2 is 25% greater than it was in February 2020, just before COVID-19 shut down the economy.

That’s what prompted inflation to skyrocket, rapidly increasing prices for food, housing, and transportation. Thus far, we haven’t seen much of a slowdown in consumer spending despite higher prices. Wall Street seems to believe that will remain the case regardless of what the Fed does next, but if consumers stop spending, then a recession will be unavoidable.

Explain for us how you leverage “market mayhem” for profit.

My system identifies stocks that have become overvalued based on several fundamental and technical metrics. That does not necessarily mean that they are certain to crash, but it does mean that they are more vulnerable to a sudden change in direction if there is any change to the narrative that is driving their current momentum.

The same herd mentality that drove their share prices up can do the exact same thing in reverse. By the way, that is also true for stocks that have become oversold. That’s why I will sometimes recommend call options on companies that I believe could rally strongly once Wall Street realizes it made a mistake.

History shows that stocks embark on a sustained upward trajectory when the Federal Reserve finally ends a tightening cycle. We appear to be reaching the end of the current cycle, but until we get definitive clarity on monetary policy, the market will be volatile and uncertain, won’t it?

Absolutely. It is only in hindsight that we know when a bear market is finally over. Before that happens, there can be several false starts that result in rapid changes in direction based on conflicting economic data.

That is why Fed Chair Jerome Powell has repeatedly stated that he will keep raising interest rates for as long as it takes to get inflation under control. At the same time, he wants to give himself leeway to not raise rates if the economy continues to cool off. That is why he cannot be definitive about what he is going to do, since that is conditional on future data that we have not yet seen.

Isn’t that sort of “mayhem” your investment sweet spot?

That is half of the equation that creates a market mayhem sweet spot. The other half is identifying sectors of the economy, and stocks within those sectors, that appear to be “priced for perfection” and therefore vulnerable to a quick sell-off if their performance disappoints Wall Street.

They aren’t hard to find since their relative valuations can be compared to their historical metrics and to their peers in the current market environment. Sooner or later, reversion to the mean will bring them back into parity. My objective is to identify those sectors and stocks just before that happens.,

Which sectors of the market look most promising to you right now?

For my put option trades, I’m looking for sectors that are overvalued and likely to decline in price in the near term. Right now, the tech sector appears to be overbought from both a fundamental and technical perspective.

So far this year, the information technology sector of the S&P 500 index has greatly outperformed the index. Also, consumer discretionary stocks have outperformed, even though they would be most vulnerable to a recession.

At the other end of the spectrum is the energy sector, which has underperformed over the same span. That makes it attractive for call option trades since it is only a matter of time until something happens to drive oil prices higher.

Once the war in Ukraine is over, price limits on Russian oil will be removed, allowing global energy prices to revert to equilibrium. Health care stocks also look cheap to me, which are down this year despite inelastic demand for most of their products.

The year-to-date rally in the S&P 500 and NASDAQ has been largely driven by enthusiasm over artificial intelligence (AI). After a severe slump in 2022, tech stocks are at lofty levels again. Do you think mega-cap tech stocks are ripe for a pullback?

Yes, I do. In truth, the big run-up in mega-cap tech stock is really nothing more than a “risk-off” approach to the stock market. Those companies are sitting on a lot of cash and could withstand a recession better than most other businesses. However, they won’t be able to grow profits as fast as Wall Street expects if the global economy contracts.

For example, Apple (NSDQ: AAPL) relies almost entirely on consumer spending for its revenue. If times get tough, a lot of people may decide to hang on to their old iPhone a while longer rather than upgrade to the latest model.

Apple is the most valuable publicly traded company in the world and as such a bellwether. If Apple hits the skids, you can expect all of the major stock market indexes to follow suit.

The New York Stock Exchange Advance/Decline line, the NYAD, hovers above its 50- and 200-day moving averages. When NYAD is rising, the stock market is in a healthy position because more stocks are rising than falling. Small-caps and financials have been in the vanguard of the rally, too. Despite the tech boom year-to-date, aren’t these signs of market breadth reassuring?

Yes, but they have participated in the rally to a much lesser degree than tech stocks. Small-cap stocks, as measured by the Russell 2000 index, have risen but they’ve still lagged the S&P 500 and the tech-heavy NASDAQ.

If Wall Street really believed that inflation was tamed and a recession was unlikely, then small-cap stocks would be up a lot more.

As for the financials sector, it has barely eked out a positive return so far this year which means Wall Street is not confident that the economy will be strong over the second half of this year.

In your view, what’s the best way to play the AI frenzy? The mega-cap Silicon Valley stalwarts are the obvious choices, but aren’t “picks-and-shovels” plays better choices?

If you are looking for call option plays, then I’d avoid the mega-cap names. In addition to being overvalued, the time premiums for those call options are inflated so you’d need a big upside move from where they are now to generate a gain sufficient to justify the risk.

That being the case, I think the safer bet is to look for companies in adjacent sectors that will benefit from the AI revolution. The fact of the matter is that the huge tech companies that everybody knows are heavily reliant on their vendors that operate in anonymity.

You don’t see their names on the cool tech gadgets that you buy, but they benefit just as much from the sale. In many cases, those “pick-and-shovel” plays outperform mega-cap stocks since they can grow their profitability at a faster rate.

Thanks for your time.

PS: Jim Pearce has developed an under-the-radar strategy to flip market mayhem into fast payouts. His technique puts into practice the theories he discussed with me in this video interview. Want to learn the details? Click here now.

John Persinos is the editorial director of Investing Daily.

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