The random walk is infamous on Wall Street. Left to their own devices, stocks go up and stocks go down. Add them all together and you have a sense of how “the market” is feeling on any given day.
Over time, that walk has an upward bias. Stocks naturally move higher more often and more dramatically than they move down. However, in seasons like this, more stocks go down than up.
And a lot of those pockets of weakness can be avoided, making the walk less random . . . provided you’re willing to do a little extra work.
Start the exercise by splitting money you would ordinarily park in an S&P 500 index fund into two equal allocations. One is for growth companies. One is for the cheapest stocks you can find.
Right now, the growth portfolio screens out all consumer stocks, which are struggling as a group to keep up with inflation. The financials, real estate and communications stocks are also going in the wrong direction.
You’ve just chopped about 45% of the market out of this portfolio. Reallocate it by doubling down on everything else: classic industrials, technology, healthcare, energy and other commodity stocks, even the utilities.
Add up all the pieces, this “growth S&P 500” portfolio is about half technology, a third healthcare and then the other sectors fill out the smaller slices. It’s down about 12.5% YTD . . . beating the broad market by about 6 percentage points so far this year, while remaining open to growth ahead.
Remember, these companies are still growing fast even in this economic environment. A year from now, they should be even bigger, justifying higher stock prices or at least not giving shareholders a compelling reason to sell.
A lot of hot stocks aren’t represented here, either. Amazon (AMZN) and Tesla (TSLA) may be the biggest and most dynamic consumer stocks, but their sector classification rules them out.
Likewise, Alphabet (GOOG) and Meta (META) are formally communications companies . . . and that sector isn’t growing this year. Factor them out. Apple (AAPL) and Microsoft (MSFT) do their work for them.
Now turn to value. Since the S&P 500 as a whole trades at roughly 17X estimated 2022 earnings, we only want to bother with stocks on this side that are cheaper than that.
The consumer stocks, again, don’t qualify. Amazon and Tesla skew the numbers too much, leaving the sector on expensive ground relative to the market as a whole.
Technology also looks a little rich. Surprisingly, so do the utilities and real estate, which have gotten crowded as investors look for a bond substitute while we wait for inflation to cool off.
Healthcare and the industrials are right on the edge. I’m going to make a judgement call and screen the industrials out as just a tiny bit overpriced right now. Healthcare can stay . . . for now.
This leaves us with energy and the commodities again, as well as healthcare, communications and the financials. And we’ve screened out about 45% of the overall market.
The “value S&P 500” we’ve created is roughly as overweight the banks as its growth counterpart is heavy on Apple and Microsoft. That’s okay. All in all, it’s down about 11.5% YTD.
Add these two portfolios back together and if you followed this approach, you’d be beating the overall market by about 7 percentage points YTD. They’re barely recovering from bear territory. You’re still in the correction zone.
What’s the secret? In the slice, consumer stocks went away entirely. They aren’t growing fast enough to qualify as growth stocks and aren’t cheap enough to represent tangible value.
They’re just noise in the S&P 500 right now. And I have to say, even though the defensive staples stocks have held up relatively well, a market-weight portfolio containing nothing but the consumer names is still lagging the broad market YTD.
AMZN and TSLA are just that much of a drag. Who needs them right now? They’ll get another shot down the road . . . remember, the index funds are locked into their holdings, but you can be dynamic.
We also skip real estate. But we’re doubling down on healthcare, energy and commodities. Guess what? Energy is the only hot sector around right now and healthcare is at least keeping up with the overpriced consumer staples group.
They’re still worth buying. I think the random walk will be good to these stocks in the future . . . and if not, we have the freedom to pivot.
This double approach is why I maintain separate growth (GameChangers) and value (Value Authority) portfolios, by the way. Sometimes one does better than the other, but over time, keeping a foot in both styles tends to do a lot better than a random walk.