The stock market has maintained its upward trending movement despite a few major pullbacks over the last seven years.
However, the level of volatility has risen since the start of the year compared to last year and this has made it more difficult to identify undervalued stocks. This has forced investors to relook their investment strategies, especially those that hunt for value plays.
When stock prices remain extremely volatile, speculation gathers pace, and this throws out the window the significant role that fundamentals play in the market value of a stock. This puts value investing under the microscope with the relationship between the intrinsic value and the stock price relatively becoming irrelevant.
However, as history has proven over time, a market correction tends to put things back in place. But until this happens, things remain highly unpredictable with stock prices moved largely by general market forces rather than the forces that drive the price of an individual stock.
As demonstrated on the S&P 500 Index chart below, that correction period might have already arrived. But again, when you look at the several pullbacks that the market has experienced over the last few months, it begs the question whether this could be another one -- and whether it could potentially result in stock prices rallying even further as has been the case.
So, how do you invest when the market keeps sending mixed signals?
Most people would rightly opt for blue chip stocks like Apple Inc. (AAPL, Financial), Microsoft Corporation (MSFT, Financial) and Alphabet Inc. (GOOG, Financial) (GOOGL, Financial), among others. The main reason behind this would probably be because of their high liquidity levels, which means that investors can always change their position in tandem with the market movement without worrying about liquidity. When dealing with thinly traded stocks, it is hard to adjust your position when you find yourself on the wrong side of the market.
Take for instance the GuruFocus chart above, which compares the SPDR S&P 500 ETF (SPY, Financial) with the stock price of Apple since the start of the year. The price of one share of Apple mirrors the same trend followed by the S&P 500 ETF. Of course, you could argue that the mega-cap blue chip stocks are the ones that actually move the Index alongside its corresponding ETF, but then again, we can see that the same trend is reflected in the relationship between the shares of Microsoft and the S&P 500 ETF.
So, where does the shift begin?
If it starts from the individual stocks, then surely the movement should represent the picture painted on the companies’ fundamentals. However, if it is nothing more than the general investor sentiment, then it would be correct to say that it starts with the Index or the ETF shift from the previous trading sessions.
So, if the overall market was down yesterday, investors would be looking to re-evaluate their top positions in various stocks to see whether it would be an appropriate time to take some profits or add to the position. Then, of course, the forces of demand and supply take effect from there on. If more investors are looking to add to their positions, the prices of the stocks in question will go up and vice versa, thereby resulting in an equivalent movement in the market indices and ETFs.
Therefore, it is correct to say that in the current market environment, it is difficult to identify blue chip undervalued stocks. But how about small cap stocks?
Since most of these are not included in the S&P 500 Index and the corresponding ETF, it is possible that some small-cap plays will not always reflect the general market sentiment, but rather what the fundamentals dictate. For instance, shares of Sorrento Therapeutics, Inc. (SRNE, Financial), which has a market cap of about $730 million are up 161% YTD.
The trend also demonstrates something different from the main market indices, which again shows that these small players can defy general stock market forces due to their low correlation with leading indices.
However, some small-cap stocks can be very tricky to trade due to a lack of liquidity. They are often subject to manipulation and this makes it also difficult to identify potential value plays.
Nonetheless, there are significant steps that investors can take to come up with an executable strategy, especially when the small cap stock also happens to be a penny stock. While trading penny stocks may appear a better option for low budget investors, they can be more complicated to trade than the average stock. But I won’t delve deeper into that. More can be found in this guide about how to paper trade penny stocks. The general idea is that at times, cheap can become expensive. Therefore, looking at the average daily trading volume is key, the higher this volume is, the better.
Another thing that investors can look at is the market cap. Some analysts have different thresholds for a small cap stock, but the most common range is a market cap of $300 million to $1 billion, again, the higher the market cap within this range the better. And then, of course, there is the stock price. While some small-cap stocks trade at a price of well below $10.00, some small-cap stocks trade at a price of well above $10.00. However, for those only interested in small cap stocks that trade at a price below $10, then looking at anything above $5.00 is better than going for those that trade under a $1.
Finally, tracking analyst commentary can also help to steer investors away from small cap stocks that are barely covered. The more the coverage of a small cap stock (especially by top financial publishers), the less likely it is to be a subject of manipulation.
Disclosure: I am not a registered investment advisor. This is just my subjective opinion and I do not own any stocks mentioned in the article.
