Cramer Remix: Here's how to approach Fed-induced sell-offs

Key Points
  • CNBC's Jim Cramer breaks down which stocks are worth eyeing when averages take a hit.
  • The "Mad Money" host also recounts his experience on Black Monday, a one-day stock market crash, and explains the different types of sell-offs investors may encounter.
Cramer Remix: Here's how to approach Fed-induced sell-offs

When the Federal Reserve is tightening — steadily raising interest rates in order to combat inflation — worries about a Fed-mandated economic slowdown can drive stocks into a sell-off, CNBC's Jim Cramer says.

When that happens, the market takes on a new form as stocks begin to factor in the possibility of rate hikes, so investors would be wise to stay nimble, he suggested.

"Garden-variety pullbacks can be gamed, as long as there's no systemic risk. But sell-offs in the wake of the Fed raising rates? Those are trickier," the "Mad Money" host said.

A common mistake Cramer sees in these situations is investors flocking to stocks with large dividends — typically consumer goods stocks or other "safe" plays investors buy in times of recession.

But those stocks can "spring back" when the Fed is tightening as bond yields, which are correlated with the central bank's hikes, start to become more competitive with stocks, Cramer warned. Instead, he suggested going for "accidental high-yielders," or stocks of high-quality companies that have declined so much that their dividends start to offer very attractive returns.

"[Fed-related declines] can lead to decent opportunities as long as you stay away from the high-yielders that become less attractive when the Fed tightens and stick with the accidentally high-yielders that might just give you that delicious bounce when the Fed is done tightening," he said.

The science of 'mechanical' market crashes

trader (c) on the New York Stock Exchange gathers his thoughts 16 October 1987 as the Dow Jones Industrial Average dropped a record 108. 36 in one day trading record.
Maria Bastone | AFP | Getty Images

Cramer knows all too well that it's much easier for investors to buy into a big stock market rally than it is to determine the cause of a major sell-off.

"[Big declines] could be the start of a bear market, they could be just the beginning of something unfathomable, or they might actually be a buyable glitch," he said.

To understand what makes buyable glitches, Cramer took investors back to 1987, when he went through one of the worst sell-offs he's ever experienced: the one-day crash that has since become known as Black Monday.

Click here for his full recap and the lessons he learned.

When it pays to sell in a sell-off

Pedestrians walk outside the New York Stock Exchange in the U.S.
Daniel Acker | Bloomberg | Getty Images

Investors have to ask themselves a serious of important questions to determine if a sell-off is worth buying or a repeat of the debilitating financial crisis that roiled global markets between 2007 and 2009, Cramer says.

First, they have to consider the economy, he explained. Is business suffering? Is employment — a key indicator for the direction of the stock market — seeing substantial declines? Is the Federal Reserve raising interest rates despite "signs of real cracks" in the business landscape, like big companies failing or unable to pay their bills?

"If the answer is yes, then you have a decline that could be deeply rooted and joined at the hip with the real economy, and that has ... systemic risk, meaning that the entire country could collapse," Cramer said.

Click here for what else you should ask yourself in a sell-off — and how to know when the market has bottomed.

The various types of 'buyable' sell-offs

A trader works on the floor of the New York Stock Exchange (NYSE) on August 24, 2015 in New York City.
Getty Images

There are many different kinds of sell-offs — from garden-variety pullbacks to wholesale breakdowns like the 2008 financial crisis — but the key for investors is knowing why they're occurring, Cramer says.

"There are all sorts of sell-offs, but unless they involve systemic risk, they're going to prove to be buying opportunities," he told investors. "You just need to recognize why the sell-off is occurring, note the signs that it might be subsiding and then take action to buy, not sell, and never to panic."

The first type of "buyable" decline Cramer addressed is a margin-induced sell-off. This happens when money managers borrow more money than they should to make investments, so when the stock market falls, they don't have enough capital to pay back margin clerks.

Click here for what it meant for the market, and to see the other types of sell-offs that tend to create buying opportunities.

Spotting a flash crash

Traders work on the floor of the New York Stock Exchange before the closing bell May 6, 2010. The Dow plunged almost 1,000 points before closing down 347 on Greek debt fears.
Getty Images

When the stock market takes huge hits that can only be described as "other-worldly," it's worth wondering whether the sell-off might be caused by something mechanical rather than some big economic trigger, Cramer said.

For example, during the flash crash of August 2015, Cramer found himself "suspicious, because some of the hardest-hit stocks were the recession-proof names, especially the biotechs, which for some reason declined harder than almost all the rest of the market."

"That shouldn't be happening if there was really something wrong with the economy. That's what people buy. Those stocks are often the safest of havens in moments when it's the economy that's at work," he said.

When the panic subsided, it turned out that computer-based trading mechanisms and the futures were behind the market's plunge, and the "strong-stomached buyers" that were brave enough to take advantage of the nosedive were rewarded, Cramer recalled.

"If you can determine whether a sell-off is caused by the mechanics of the market breaking down, then you might have an incredible buying opportunity. First, though, you have to figure out whether the sell-off is related to the fundamentals of the economy. If it is, then stay tuned. If it isn't, stay tuned anyway, but recognize that you have a first-class panic on your hands and nobody ever made a dime panicking," the "Mad Money" host concluded.

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