Dr. Duarte’s “Risk Inoculation” for 2024
November lived up to its reputation of being positive for stock returns. The calendar is finally on our side again.
In the month of November that just ended, the Dow Jones Industrial Average shook off its three-month losing streak, rising by 8.8% and posting its best month since October 2022. The S&P 500 rose more than 8% and the tech-heavy NASDAQ was up 10%, both notching their best month since July 2022. The small-cap Russell 2000 rose 8.8% for the month, its largest gain since January.
Investment-grade bond returns also were strong in November, with the Bloomberg U.S. Aggregate Bond index rising 4%, supported by the sharp decline in yields.
Resilient economic growth, falling inflation and easing bond yields are major ingredients suggesting that a “Santa Claus rally” is in the cards for December. Prospects for the new year also look strong, with expectations that the economy and corporate earnings will pick up steam and the Federal Reserve will cut rates by mid-2024.
But nasty surprises always lurk around the corner. The Russia-Ukraine and Israel-Hamas wars, our dysfunctional Congress, domestic threats to American democracy, still-uncertain monetary policy, a higher cost of capital, consumer fatigue…a litany of factors could derail markets.
This Advent Season, instead of a visit by Santa, investors might get confronted by a boogeyman. I like to tease my grandchildren by warning them about Krampus, a horned anthropomorphic figure in the Alpine folklore of Europe who terrorizes misbehaving children.
As December gets underway and a new year looms on the calendar, now’s an opportune time for me to interview my colleague Dr. Joe Duarte, chief investment strategist of Profit Catalyst Alert. Dr. Duarte is an expert at generating market-beating gains. He’s also adept at mitigating risk.
Dr. Duarte has been a professional investor and independent analyst since 1990. He is a former registered investment advisor and author of the bestselling Options Trading for Dummies, and several other books including Market Timing for Dummies and Successful Biotech Investing.
Joe also is a medical doctor. When he’s not advising investors, he’s treating patients. My questions are in bold.
Is there an investment school of thought that you follow?
The stock market moves the economy now in a reversal of the traditional relationship. I call it the MELA system: M for markets, E for economy, L for people’s life and financial decisions, and A for algos (artificial intelligence).
The four components are centered by the state of the 401k plan from which people borrow and make future decisions. Bull markets make 401k plans rise in value. People feel good and buy houses and cars. Algos accelerate this dynamic via stock market trend enhancement and social media.
This in turn makes people feel wealthier. It’s what the Federal Reserve calls the “wealth effect.” And this wealth effect gives people a good feeling about the future and makes them spend money in the present.
Since the economy is fueled by consumer spending, the economy grows. This in turn leads to improving corporate earnings which increases stock prices and again fuels the 401k, and so on in a virtuous cycle.
The final step is the role of artificial intelligence, aka algos. In the real world, social media allows for the near instant transfer of information.
When all these factors are combined, the net effect is that market trends last longer due to the virtuous cycle. Unfortunately, the reverse is also similar. As we saw in March 2020, a 30% drop in stocks can take place in six weeks. And as we experienced, the drop in the market was almost instantly followed by a caving in of gross domestic product.
Once I gauge the state of the MELA system, I move on to the markets, where I follow four major principles:
- Don’t fight the Fed.
It’s folly to fight the interest rate trend. When the Fed is easing, either via lowering interest rates or quantitative easing, the odds favor an increase in stock prices. That’s because interest paying securities yield less and stocks offer better odds of gains.
- Don’t fight the market’s momentum.
This is a corollary to “Don’t fight the Fed.” It’s actually simple. When the Fed lowers interest rates, look for stocks to buy. And as long as the market keeps going up, keep buying.
- Study the New York Stock Exchange Advance Decline line (NYAD).
This indicator has been better than the major indexes as a gauge of the true market’s trend for decades. But since the 2000s, it’s been even better. That’s because large-cap stocks such as Amazon (NSDQ: AMZN) and Microsoft (NSDQ: MSFT) distort the price of the S&P 500 via their market capitalization.
In a well-functioning market, most stocks trend higher in bull trends, and lower in a bear trend. However, there are times when the indexes and the NYAD don’t correlate.
When divergences go on for several days or longer, it’s a sign that the market is malfunctioning and that risk to the downside is increasing.
Fortunately, the reverse is also true. In this case you would see flat or down trending indexes but a rising trend in NYAD. By comparing the action in the NYAD to that of the indexes, you’re able to make better decisions. And right now, the NYAD is rising, which is bullish.
- Use a hybrid approach when picking stocks.
I combine the approaches of the best analysts. I’m part Martin Zweig, part Warren Buffet and Peter Lynch, and largely a chartist.
My first step in stock picking is reviewing price charts. When I see an attractive looking chart I follow it with a deep dive into the business of the company, much as what Buffet might do.
I look at earnings, valuation, and I spend a lot of time reading earnings calls transcripts and getting a feel for how management deals with good and bad times.
As 2024 beckons on the calendar, which sectors look the most appealing to you?
Over the long term, I still like those areas of technology that allow online collaboration. Collaborative platforms and the cloud are likely to be the most resilient remnants of the COVID pandemic. People have learned that working from home is not just possible but, in many ways, it’s better than being at the office.
Any platform that lets this dynamic unfold is likely to have good sustainability for the foreseeable future.
The Federal Reserve is likely on hold on its interest rate increases barring major negative surprises. That sets up the potential for a continuation into 2024 of the year-end rally. Investors who missed the rally will be playing catch-up. In the short term, this will favor groups which have already delivered big returns as money managers resort to window dressing to impress their clients.
Retailing stocks offer a short-term seasonal opportunity to participate in the year-end rally. Yet, their longer term prospects are uncertain given the potential for a sluggish economy.
During this time of the year, value investors often encounter excellent long-term opportunities to buy into beaten up areas of the market before the crowd. In the coming months, the laggards of 2023, such as real estate investment trusts (REITs), should become leaders as interest rates fall.
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