An Investing Strategy For A Confusing Two-Market Era

There is no such thing as “the stock market” right now. There is no one, unified market that can be considered en masse. Instead, we have two distinct markets, responding independently to two completely different sets of stimuli. In the short term, trading success depends on recognizing and understanding that and devising a strategy to benefit from it.

On the first hand, we have the traditional market drivers, things like the industrial, transport and materials sectors. Those stocks are keying off the news about Covid-19. As states began to re-open, they bounced far and fast. However, now there is growing evidence that states that re-opened as quickly as possible are paying a price, and those stocks have faltered as a result.

There has been an increase in reported coronavirus cases in most of the states that re-opened early.  As a result, new cases in the U.S. overall, after dropping for two months, have begun to increase again. The data also tells us that this is not just down to more testing, as the percentage of positive tests is also increasing in most of the states seeing increased infections.

Figure 1: Source: NY Times

In that situation, it is hard to buy the first market with any confidence.

Then there is the second market, made up of stocks that could conceivably benefit not just in the short-term, but also in the long-term from changes in consumer behavior wrought by those restrictions. Those are the Zooms (ZM), Squares (SQ), Netflixes (NFLX) and Amazons (AMZN) of this world.

Even though these are stocks that could, in theory, prosper in another round of lockdowns, that is not what's powering them. It is incredibly hard to walk back a relaxing of restrictions, and in many places there seems to be a willful disregard for the fact that it will cost lives. For some, their view is that it is just the price we have to pay. Either way, even as the hard-won progress of the last few months is tossed out the window, very few people think we are staring at another round of “stay-at-home” orders in the South.

Even if you do believe that we could be headed for another lockdown scenario, it is hard to justify buying the second set of stocks on perceived value. I mean, as obvious as the long-term case for say Zoom, with a trailing P/E of just over 1,400, or Square at a roughly 150 multiple is, those numbers would suggest that a lot of the optimism is priced in. And yet they keep going up, and it is because of the main driver of that second market: the Fed.

The Fed is handing out huge amounts of cash that has to be invested somewhere. With the first market struggling, that money finds its way into the second, regardless of value. Things like airline and cruise ship stocks may have more long-term upside than the stay at home gang, but it is hard to justify putting all that cash into them as coronavirus cases are resurgent. A P/E of 150 for SQ still looks better than, for example, the 6 offered by Delta (DAL) if there are growth prospects on the one hand and an existential threat on the other.

There is no point in fighting the Fed, so both markets could still push higher for a while. If that is the case, or if the coronavirus news continues to worsen and we turn down, the second market can continue to outperform. The best trade here, then, is one that would benefit from that outperformance in a bull or bear market.

Using the indices is not perfect for that trade as there is some crossover, but it has the advantage of being both simple and liquid so establishing a short position in the Dow, while simultaneously long the Nasdaq makes sense. That can be quite easily achieved, even in a long only equity account, by buying DOG, an inverse Dow tracker, and QQQ, the Nasdaq tracker, simultaneously. That way, if the Nasdaq continues to do better than the Dow, in either a bull or bear market, you make money.

Sometimes, the more you study a market, the less clear it becomes what your positioning should be. That is the case right now. I can see both sides of the argument here. Overall stock prices are completely disconnected from the reality of massive unemployment, a huge recession and the prospect of the “recovery” turning out to be based on false hope or political calculations rather than defeating the virus.

And yet, the Fed is handing Wall Street billions of dollars every month, while simultaneously depressing interest rates and therefore forcing that cash into stocks. A paired trade long the Nasdaq and short the Dow looks like being a winner whichever of those influences proves the most powerful over the next few weeks.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Stocks Economy