Sometimes all it takes is a scary stock rotation to fuel a rally, Jim Cramer says.
"When money is flowing into stocks, with the mutual funds buying in endless waves and the hedge funds desperate to own stocks rather than shorting them, then you're in the land of the thousand bull dances and you don't have to worry about where the fuel for a rally is going to come from," the "Mad Money" host said.
When no money is flowing into the market, that is when powerful moves in stocks and sectors can occur, Cramer said. This is because when investors are reluctant to invest, money will be pulled out of the least exciting groups of stocks and rotate into sexier names with more lift.
But here is the problem with rotations: without new money flowing in, gains often become zero-sum and will run out of fuel. The leaders will run out of steam with nothing to drive them higher. That is when the worst possible rally can occur — a rally in the wrong stocks.
These "wrong stocks" names are those that signal a slowdown or recession. Areas like food and drug stocks become the new market leaders.
"You never really want to see any of the consumer staples roaring higher in a sustained advance because it means people think the economy's going to either get worse or simply stay in awful shape for a long time to come," Cramer said.
Cramer considers seeing a stock like Altria, PepsiCo or General Mills spark a powerful rally one of the most horrifying things in the stock market. Often that can cause an immense amount of damage, unless there are vast sums of money coming in from the sidelines.
One of the worst myths out there, according to Cramer, is that the market is always rational and makes sense. This is not true.
On any given day, the market can be totally wacky for reasons that do not make sense. Sometimes stocks go up when they should have gone down, and sometimes entire sectors move for ridiculous reasons.
"Never assume that just because something happened it has to make sense because the market is always supposed to make sense. That's nonsense," Cramer added.
So, when everything in the market or in a particular sector goes down, instead of assuming that the issue pertains to the fundamentals of the underlying company, Cramer suggested to ask yourself if it could have been caused by an out of control hedge fund or Wall Street money management. Then realize that the market's irrationality can be your opportunity to profit.
Cramer's motto in a downturn is to buy broken stocks, not broken companies. When there are huge losses on the market, he said, investors have the opportunity to buy good companies with stocks that have taken a beating because of the market.
There is a huge difference between a broken company and a broken stock, and being able to thrive in a sell-off requires knowing the difference.
That is why Cramer said the first thing to do amid a market-wide sell-off is look at the companies that caused it. They are probably broken.
"If you're looking at a company that is part of the reason for a correction, you're looking at a broken company. Those are directly in the blast zone and certain to be obliterated," the "Mad Money" host said.
His first approach is to look for stocks that have pulled back from their highs during the sell-off. The new-high list is always a great place to start looking. Stocks on that list also tend to be expensive, which is why a big decline may be an opportunity.
Specifically, he looks for the stocks that were knocked off the new-high list and are trading a couple of percentage points from their 52-week high. Those will be the money magnets of the market.
However, Cramer warned that not all of it will be worth buying. Some may come off the list because they are damaged goods. So, homework is still important.
The second kind of stock that Cramer looks for during a gigantic sell-off is the type with dividends that become more attractive as their share prices go lower. Just as the 52-week high list is useful for stocks on a downturn, also keep a shopping list of stocks to buy if only their dividends were a little higher.
What does a market correction have to do with a dividend or yield?
When a market correction occurs, the price of the stock goes down and the yield goes up. Cramer loves it when a sell-off is so severe that an "accidental high-yielder" is created.
One of the most important lessons that Cramer learned over the years is don't trust all buybacks.
"They aren't created equally and they aren't all a place to run to in a selloff. In fact, many buybacks disappear when times get tough and can't be relied upon as we saw when the oils came crashing down when oil plunged in 2014," Cramer said.
Buybacks are when companies repurchase their own shares on the open market in order to take them out of the equation, thus reducing the number of shares outstanding and boosting the earnings per share. Often buybacks are used as a way for companies to reward shareholders with their cash. However, Cramer likes dividends more because of the downside protection and preferred federal taxation status.
Over the years, buybacks have become very popular. Companies spent about $1 trillion more on buying back stock than on paying dividends in the past decade. Unfortunately, Cramer has seen that these buybacks have not given shareholders the value that they expected.
"So, when you see a company with large buybacks and a puny dividend, you should be suspicious rather than bullish," Cramer added.