The steely resolve required in investing sometimes requires the nerve to not participate in the rally as much as it is to take risk. So it has been the past year I’m the market. Some readers and followers have given me a tough time for remaining negative on crypto, shunning SPACs as well as meme stocks. I get no joy from seeing these assets fall dramatically in value. It’s a painful lesson that I had to learn as well as a young investor when I first started out, but nonetheless many of us old heads saw this coming.

The question now is where investors can focus now that high flying tech isn’t leading the markets. In this post I want to review some of my calls that should perform well in a down market as well as take advantage of volatility.

First the facts. There is not likely to be a big blow up in stocks. As seen below, the stock market has returned on average about 7.4% in the 12 months after the first rate hike, which is now expected to come in March.

Despite this, stocks tend to display a lot of volatility during the period of rising rates. This is because the economy is in the middle of the economic cycle. The bounce back boom period following the crash has happened (look at returns since March 2020) and now the direction the economy takes is less certain. Investors are searching for signs of direction as to where and when things will go next. This can mean periods of close to bear markets followed by steep rallies.

Still in all this there will be sectors that will outperform. My 2022 equity market preview looked at a few sectors that I thought would perform well this year given the conditions. A market correction is a great time for investors to see if their hunches, theories and outlooks are playing out or whether they need to reassess.

January Performance

The below performances are based on the investable equivalents of the indexes mentioned. For example for the S&P 500 I used the State Street SPDRs investment trust and for the Nasdaq I used the Invesco QQQ Series I Trust to track the Nasdaq 100.

S&P 500 – Down 8.75% year to date

Nasdaq – Down 13.39% year to date

Russell 2000 – Down 11.9% year to date

REITs Index – Down 10.9% year to date

Other notable stocks and asset classes that I have written about in the past year are listed below:

AMC – Down 57.8% on the year

HOOD – Down 30.4%

Bitcoin – Down 21.6%

It has been clear for some time that there are a number of different stocks are essentially worthless but popular with the Reddit crowd. I profiled how the Robinhood IPO seemed to be a massive giveaway to insiders rather than a profitable investment for retail investors. I also looked into AMC and since I did, it seems that they have issued even more equity than when I valued the shares at about a dollar a share. Now they are likely worth less than that yet still trading around $16 a share. It still remains a great short candidate for anyone willing to stomach the volatility.

My Sector Performance

So given this dour market, what has been the performance of some of my recent picks to do well in 2022? Below you can see the sectors and their year to day performance.

Value – Down 2.7%

Energy – Up 13.3%

Financials – down 3.6%

Value is getting ever more attention and many seem to think that the great rotation into value from growth is now afoot. It would seem so from the performance of the Nasdaq compared to the sectors above. This likely can’t be exemplified better than the performance of Cathie Woods ARK ETF versus the performance of the ultimate value stock: Berkshire Hathaway.

Energy will be volatile but is likely to remain on a tear for the year. International tensions in Russia, a cold winter in Europe and the continued reopening of wealthy countries promise for this to continue to be a banner year for energy.

I continue to be bullish on financials. Rising rates and strong balance sheets as well as continued consolidation will favor the 4 large universal banks. These are namely JP Morgan, Citi, Bank of America and Wells Fargo. Regional banks tend to do well with a strengthening economy and consolidation is of these smaller names is creating opportunities in small stock names that may be acquired. It’s an opportunity now for small investors to snap up smaller regional banks which may get acquired by ever larger ones. Names like Signature Bank, Regions Bank, People’s United Financial and others remain attractive targets for larger but not too large bank names like Huntington and KeyBank, which need to grow further to stay competitive with their megacap peers.

Interesting Trades Remain

Besides the current downturn being a good buying opportunity for long only purchases. It’s also a good time to take advantage through stocks that rise when volatility rises. I have profiled a few of these stocks in the past and want to review them here.

For the pure volatility ETF’s, investors are already late to the party. These are ETF’s that purchase CBOE VIX futures to offer traders a volatility hedge. When volatility increases, these ETF’s quickly increase in value. The performance of a few I have profiles previously are below:

VIXM ProShares VIX midterm futures ETF – Up 5.4% year to date

IPathS&P 500 VIX Short Term Futures ETF VXX – up 31.2% year to date

VIXY – Also up 31.2% this year

To profit from these, you would have had to anticipate the volatility this month and get into these ETF’s in early January. The trade now may be to buy puts on these ETF’s to profit when volatility actually falls and tends to return to a more steady state.

If buying puts on a futures ETF is not you cup of tea, another option to benefit from volatility is to purchase one of the ETF’s that tracks the CBOE buy write index. These ETF’s use derivatives to match a very specific strategy: of an investor who holds the underlying index and sells covered calls just above the current price to collect some income. Despite the fall in prices, volatility helps the price of options even if they are out of the money. The below ETF’s pay out their dividends on a monthly basis and even though they fall in value with the market, this is partially offset by the increase in the options that they implicitly hold. It makes for some upside equity wise as well as big payouts when the market does actually fall. Below you can see their recent performance along with their current payout which helps offset the losses.

XYLD – S&P 500 Covered Call ETF – down 6.13% this year but yielding 9.58%

To put this another way, the above ETF, we’re the market to climb back, would be looking at 6% upside in price while yielding 9.58% for a total potential rerun of 15.58% if prices climb back to previous levels. Not bad considering the 8.8% drop in the index overall.

QYLD – The covered call Nasdaq ETF – down 10.2% year to date and yielding 11.8%

To give an example of how QYLD bounced back, in 2020 shares fell by 25% to around $18 a share from $24 but then rallied all the way back before year end while yielding 12-13% at the time. That’s an almost 50% return compared to the 41% return the Nasdaq saw from its February 2020 peak and climb back a year later.

The one downside of these covered call ETF’s however is that the payouts are taxed as ordinary income which really bites into after tax returns. The capital returns are almost always preferred by individual investors because the gains can be deferred indefinitely. If we ignore these, then the buy write indexes can beat even the indexes themselves over long periods as well as exhibited by the lazy trader.

The Takeaways for Investors

The major takeaways for investors shouldn’t be that it’s easy to pick which sectors will win. We are only a month into the year and there are a lot of other factors that could come into play which could skew returns in any direction.

The main takeaways from my perspective would be that it pays to be skeptical. The simple logic I have argued in the crypto space is that Bitcoins may be limited in supply but there isn’t any real difference for investors between a Bitcoin and an Ethereum. Essentially this creates an unlimited supply of cryptocurrency, rendering them worthless.

I never touched the SPAC craze for the simple reason that I knew these were blank check companies Sur Inc g off of the game of their founders, not necessarily true skill.

The other important takeaway is that valuation still matters. We have to be cautious in how we describe valuation because some markets like the US have remained expensive for many years on end. But the relative valuation of a market in relation to its historical valuation does matter and this is what had kept me away from tech and the hot stocks for much of 2021 and the end of 2020. The cyclically adjusted P/E ratio, meaning ten year average earnings divided by the current price is nearly as high as it was during the dot com bubble.

I encourage everyone to go back and look at a documentary of the dot com bubble like this one here. Many of the things we are witnessing today are just repeats of that era. People were quitting their jobs to trade and everyone talked about a new normal with transformative tech. Not long after the market fell 40% over 2 years. Now some of that had to do with the war on terror and the shift in priorities for many Americans as well as a realignment of valuation but it should serve as a cautionary tale for investors going forward.

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