Stock market swings got you reeling? Answering 6 questions will help
This sure has been one tough market these past few weeks. One day, stocks are rallying on renewed hopes of a December Fed rate cut. The very next day, they’re weighed down by worries of an impending AI bubble. It’s no surprise that the CBOE Volatility Index (VIX) — widely known as the “fear index” — has been elevated in November and hit its highest levels since President Donald Trump’s “Liberation Day” back in April. Down days in markets are always in the cards, of course. But they are especially frustrating when the data doesn’t seem to support the price action. After all, we’re closing out a strong quarter, in which 83% of S & P 500 companies that have reported so far have beaten Street earnings expectations, and 76% have beaten revenue expectations. Yet that success has been met with relentless selling, including in some of the best performers. Frustrating as that action can be, it also tends to present opportunities. Investors just need to know where to look and how to strategically put money to work. To help with the search, we’ve come up with six questions to ask yourself in a tough tape. How you answer will help determine whether you bail on a stock, maintain your current exposure, or hold your nose and buy more. 1. Has anything changed at the company or in its industry that could impact future earnings? We are all about the fundamentals, meaning we care far more about a company’s financial health and earnings outlook than its stock price. That’s not always easy. Price action shows how much money you make or lose on a given day. However, for long-term investors, it’s critical to stay hyper-focused on long-term earnings power. As legendary investor and economist Benjamin Graham once said, “In the short term, the stock market is a voting machine.” Over the long term, stock prices tend to catch up with a company’s performance. Of course, if you determine your investment thesis to have been broken for some reason, you might not want to stick around at all. Bad news can get priced in, and stocks can overreact; a negative update in and of itself doesn’t mean you should sell the stock. However, it does mean we need to objectively reassess whether we still want to be involved. On the other hand, if your analysis of both the company’s own merits and any industry-level changes, such as a regulatory change, leads you to conclude that the long-term earnings story remains intact, you may see a buying opportunity if shares decline. First, there are a few more questions that should be answered. 2. Has anything changed from a macroeconomic perspective that could impact what investors are willing to pay for the company’s earnings? The first question concerns earnings power; however, that’s only one part of determining a stock’s value. That’s the bottom-up view. Now, we have to consider a top-down view, which will help inform us of what multiple investors may pay for the earnings outlook determined in the prior question. Think about taking a worldview that incorporates everything from geopolitical events to monetary and fiscal policy and macroeconomic data points. From there, you can figure out what this worldview means for various sectors of the economy and the companies in those sectors. The idea is to use this top-down analysis to determine whether anything has changed that may affect the economy’s outlook, which could influence sentiment and, in turn, the multiple (or discount rate) investors apply to valuation models for the foreseeable future. Are inflation estimates rising, prompting the Federal Reserve to raise rates or halt rate cuts? If so, you would expect the multiples placed on earnings estimates to contract, or for the discount rate applied to future earnings to increase. Layering in this analysis will help determine a price target for the stock, which, at the end of the day, is simply earnings per share (EPS) multiplied by the multiple investors are willing to pay for those earnings. Where the stock trades relative to the new price target will inform the course of action. However, there is one more step we should take to refine our price target further. 3. What is the multiple, in relation to both the stock’s historic valuation and the market? Once you have a sense of whether the multiple should expand, contract, or stay flat, given your top-down view, consider what that has historically meant and how it compares with the market as a whole. That means you need a frame of reference — typically, the multiple the stock has historically traded at, in relation to both itself and peers, as well as the market as a whole. Don’t forget to account for any changes in the growth rate (for this, we use the PEG multiple ) or investor sentiment, which may cause investors to pay up or value earnings less than they used to, all else being equal. We determined an initial price target by answering the second question; with this third question, we aim to refine that target and ground our thinking in the stock’s historical valuation dynamics. The idea is to get a sense of how the story has changed relative to history to determine whether investors will pay as much as they once did, the same, or less, given the story as it stands today. It’s not enough to simply determine how much a multiple should expand or contract; we also have to consider the magnitude of the expansion or contraction. Take Wells Fargo . We argued that as regulatory milestones were reached, the multiple would expand. That’s great, but by how much? To determine that, we could look at where it was before its regulatory issues, but that was so long ago. We would argue it makes more sense to look at what a well-run bank trades at and take that as our indicator of where the multiple could go. For example, we might look at JPMorgan and use its multiple as the upper bound, given that it is considered the best in the business. From there, we can adjust that based on the multiples we see at other firms like Bank of America or Citigroup , and using those three valuations, try to determine where a reformed Wells Fargo deserves to trade. 4. What is the chart telling you? Once you have a price level to step in and buy more shares, given the fair value estimate generated in steps one through three (which is what a price target is, an estimate of fair value), it’s worth taking a look at the chart to determine possible support levels. There are many tools for technical analysis, but given our focus on bottom-up analysis, we prefer to keep it simple or defer to true market technicians, as Jim Cramer often does on ” Mad Money .” Some things to look for include where the 50-day and 200-day simple moving averages cross, longer-term trend lines, or horizontal support lines. In addition, keep an eye on volume. Higher volume means the moves you’re analyzing carry more weight since they were made with more participation. One might also look at tools like the relative strength indicator, a momentum indicator that helps indicate whether a stock has reached oversold or overbought levels. If you see support coming in at a key level that has historically attracted buyers, you may want to buy more shares. However, if the chart shows that long-term support hasn’t held — for example, the stock breaks down further after falling below the 200-day moving average — hold off, as the stock could be a “falling knife” at that point. In those cases, since we determined in the earlier steps that we still want to be involved for fundamental reasons, we need to be patient for a better price level. Wait for the selling to slow and look for the stock to stabilize and maybe even regain some ground before stepping in. 5. How big is your current position? Once you have a buying level in mind, you have to decide how much money to put to work . Think in terms of percentage weighting versus the entire portfolio, cash included. For the Club, a full position is in the 5%-6% range. This means we aren’t going to add to a name with a 5% weighting and will look to trim names that start to grow beyond 6% . What a full position size is for you, and how large your existing position already is, will determine how aggressive you should be. If the position is new and has a small current weighting, you may be able to get a bit more aggressive, knowing you still have room to add further weakness. If the position is a relatively decent size, say 50% of full weighting or more, consider waiting for larger declines so that each buy can have a greater impact in reducing your overall cost basis . 6. Are there any catalysts in the near term? The last thing to consider before making a trade is any events on the horizon. Having factored in all the information we can, we want to consider what updates are coming down the pike and how much they might influence the investment thesis. Consider any upcoming catalysts that may prompt you to become more aggressive, such as upcoming economic data or a legal dispute settlement. Not all events are treated equally. For example, we tend to be cautious before quarterly earnings — even if you gauge the headline numbers correctly, predicting the investor reaction to the release is another beast entirely. Just look at Nvidia , which reported a blowout quarter and was quickly met with a selloff. (See here for a full list of the stocks in Jim Cramer’s Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
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