We often hear the phrase “A rising tide lifts all boats” associated with the economy or sometimes with the stock market. What most people fail to see is that the opposite is true as well; a falling tide drops all boats.
With the stock market rising essentially for over eight years now, the bull market has definitely lifted most boats, even those with holes in their hull. The rally in the S&P stalled a little in 2015 and then an upwardly sloped trend channel dictated trade from the beginning of 2016. The last few months have seen the trajectory of the rally steepen as the index has risen in eight of the last nine weeks and the index has moved above the upper rail of the channel.
With the rally steepening, it is concerning. It is concerning that we are overdue for a decline of some magnitude. We haven’t seen a five percent correction in the market since June of ’16, meaning it has been 336 trading days since we have seen a correction, making this the fourth longest stretch without a correction since 1950. The longest such stretch was 394 trading days and that occurred from December 21, 1994 through July 12, 1996.
Given how long it has been since we saw a correction, let alone a bearish phase in the market, I set out to find stocks that could be especially vulnerable during a pullback. I looked for stocks that have moved sharply higher in the past year, but didn’t have the fundamental performance to match the technical performance.
To do this, I looked at three indicators in Investor’s Business Daily: the EPS rank, the SMR rating and the Relative Strength rank. The EPS rank and the SMR rating measure a stocks earnings growth, sales growth, profit margin and return on equity while the Relative Strength rank measures the stock’s price performance compared to all other publicly traded stocks. I looked for stocks with high relative strength rankings and low EPS ranks and low SMR ratings.
One of the other criteria I looked at was trading volume of at least 100,000 shares per day. There are plenty of stocks with high relative strength ratings and low EPS and SMR ratings that trade less than 100K per day, but shorting them or buying put options on them would make it tough to trade. After taking everything in to consideration, I compiled a list of 42 stocks from different sectors and in different industries.
I believe that these stocks are the most vulnerable to sharp declines should we enter a correction or bearish phase in the market. They have been lifted by the rise in the overall market more so than their own fundamental performance, therefore it stands to reason that if the market starts to decline, these stocks will move more sharply to the downside. The one sector where that is difficult to calculate is the healthcare sector and specifically the pharmaceutical and biotech companies. It is far more common for a stock to move based on potential in these industries than others.
A correction may not come tomorrow, next week or next month, but we are due for one and when the market starts to show signs of weakness, the list of stocks above should make for good bearish plays. Again, you have to be careful with biotech and pharma companies as they tend to move more on trial results and such.