For professional investors, calling for a "stock picker's market" at the start of a year is a bit like Capitol Hill staffers saying there's room for bipartisan compromise on needed legislation as a new Congress is sworn in. It's a popular proposition, the way things are supposed to work, and what the pros are presumably being paid for: On the Hill, to work out differences and make effective laws; in the market, to select the most attractive stocks through company-by-company fundamental work. In reality, electoral expediencies and a polarized public undermine bipartisanship, and in many years the market either behaves as one big entity steered by macro forces, or the biggest stocks dominate the indexes and make it tough to beat. For investors three weeks into January 2022, though, the elements of a genuine stock-selector's market might be arranging themselves, visible only by squinting through the current broad-scale retreat from risk. It's a transitional moment for the economy, with Fed-sponsored stimulus soon to be reduced and economic tailwinds waning at the same time. The most expensive, adrenaline-juiced stocks have been smashed while "quality" names have begun to distinguish themselves. Earnings disappointments are being punished so far, across the culprits' entire sector (JP Morgan and Goldman Sachs sank the banks, Netflix undercutting Walt Disney and Amazon). A chance to make an informed distinction between blameless babies and dirty bathwater? Perhaps. The sheer scope of the damage across the market is one prerequisite for picking up dented but otherwise valuable merchandise. With the S & P 500 not quite 9% off its intraday record high set Jan. 4, three of every ten stocks in the index are down at least 20%, nearly half have shed at least 15% and more than 40% of all Nasdaq components have been cut in half. And now that the selling pressure has made its way to the top of the mega-cap tier, the equal-weighted version of the S & P 500 is outperforming the standard market-cap-weighted benchmark by nearly two percentage points in the first three weeks of 2022, a decent advantage over a short stretch. The Arrow Reverse Cap 500 ETF (YPS) , a tiny fund that weights the S & P 500 stocks in reverse size order, has done even better than the equal-weight, even as mid-cap stocks have lagged. This isn't a sign, in itself, that winners (or outperformers) are suddenly easy to find, but it's a hint that it's becoming worth an investor's time to look beyond the headline indexes. Bigger hunting ground And, for better or worse, there is a greater supply of tickers to wade through than there have been in years, the result of a gushing spigot of IPOs and SPACs that has flooded the Nasdaq in particular. For years, the notion of a "shortage of stocks" was a talking point among market bulls, with the decline in total listings since the '90s somehow offered as proof that we were running out of public companies and forced to inflate those that remained. This never was quite persuasive. Most of the decline in the ranks was from penny stocks going away and sub-scale companies opting out of more tightly regulated public markets. But for sure the buy-and-hold approach of private-equity firms, collecting hundreds of companies into giant funds, did thin out the choices to a degree. Now there's the opposite issue, so many untested and discarded smaller companies without sponsorship. The kind of hunting ground that hedge funds and "special situation" investors might find rewarding, on the long and short side, somewhat like the early 2000s after the late-'90s IPO boom and tech-stock collapse. The valuation extremes have largely been concentrated in the biggest and most beloved growth-company leaders and in the unproven, unprofitable stocks (emerging cloud software, niche e-commerce, SPACs of every variety) that boomed and busted over the past 18 months. The Nasdaq 100 forward price/earnings multiple has leaked lower from 31 to about 26, yet that still leaves it above where it stood before the pandemic valuation expansion. The market-cap-weighted S & P closed Friday just under 20-times forward earnings, the lowest in two years though likewise above prior cycle highs. Yet the equal-weight S & P is near 2018 levels around 16-times, while the S & P Small Cap 600 (not shown in the chart) has ducked beneath 14. Valuation is more context than catalyst, a framework for handicapping forward returns and measuring investor enthusiasm. Yet here again the rank-and-file stocks in the market have less-demanding multiples, even if smaller companies' profits are more at risk in a bumpy economy. Searching for quality The market is also distinguishing among various flavors of "quality," a popular attribute among strategists entering 2022 as the economy and market are expected to migrate from a "rising tide lifts all boats" backdrop to one where a vessel's relative seaworthiness matters. Sturdy profit margins, strong cash flow, solid balance sheets are the hallmarks. The iShares MSCI Quality Factor ETF (QUAL) would seem to suit this approach, but this month is trailing the S & P 500 and is being trounced by somewhat similar baskets such as iShares Dividend & Buyback (DIVB) and VanEck Morningstar Wide Moat (MOAT) to the tune of more than five percentage points in three weeks. A surplus of tech and not enough financials are hurting the Quality Factor, as defined by MSCI. To reiterate, the prospect of a stock-picker's market is plausible but would likely not take full shape until the current high-stress correction crescendos or bottoms soon. For stock selection to work well, individual names need to move independently of one another based on something beyond macro anxieties or systematic index flows. The CBOE Implied Correlation Index measures the degree to which options are pricing stocks for collective or independent movement. It has surged toward 2021 highs (in late September, not long before a good trading low on Oct. 3). Spikes are typical of a rapid sell-off, and a signal to watch for signs the fever has broken with a rapid descent. There is no doubt the skittish start in January suggests a change of market character versus 2021, when the steepest pullback didn't even reach 6% in the S & P 500, investors were happy to let equity exposures climb unchecked and sector rotation was well choreographed to support the indexes. Time for a bounce? In the short-term, the elements of a decent trading low are starting to arrange themselves. The tape is about as oversold, based on various breadth and momentum readings, as it's been since the spring of 2020. The S & P 500 closed below its 200-day average for the first time since mid-2020. In early 2018, such a retreat to a rising 200-day line furnished a perfect bounce and eventual recovery to a new high; in late 2018, the market sliced right through on the way to a fairly rare 20% decline outside of a recession. Credit markets today, for what it's worth, are a good deal steadier than they were then. Jeff deGraaf of Renaissance Macro research on Friday afternoon noted a helpful extreme in the put/call ratio, showing the most demand for downside protection since the Covid crash. "Sentiment is one of the necessary components of a tactical low," he wrote. "Now we've got it." The weekly American Association of Individual Investors survey leans in the same direction. These are the atmospheric conditions that should generate some relief, necessary but not sufficient. Traders itchy to catch a relief rally might be hoping for another emotional flush in coming days, after Friday's options expiration that featured a new one-day record for option volumes. It would no doubt be led by the worst-hit, highest-beta hardship cases. Asking for the ideal setup doesn't always bring it, and any bounce would face a high burden of proof. But should the market seize on the tactical extremes to relieve the pressure and stabilize, it should keep stock pickers busy for a while.
Traders on the floor of the NYSE, Jan. 21, 2022.
For professional investors, calling for a "stock picker's market" at the start of a year is a bit like Capitol Hill staffers saying there's room for bipartisan compromise on needed legislation as a new Congress is sworn in.