A couple weeks ago, I introduced the concept of a “controlled burn correction.”
A controlled burn is one where only certain areas of a forest are targeted, often to remove old growth so that new growth can prosper.
So a controlled burn correction is one that targets specific, overvalued areas of the stock market. And as we’ve seen, this controlled burn correction has taken a big chunk out of biotech and tech stocks but has left the rest of the stock market relatively unscathed.
I noted how absurdly valued stocks had fallen, like Amazon (NASDAQ: AMZN), which fell 25% from $400 to $300. Amazon now has a P/E of 474!
Or how about Athenahealth, which fell 47% from $200 to $107 a share. It looks so much better now that its forward P/E has fallen from 170 to 92!
I kid, of course. These stocks still look pretty expensive to me.
Now, broad market corrections often start with the momentum stocks and then spread to other more stable names. And this controlled burn correction has spread… but not where you might expect.
Momentum names in biotech and tech are still down, but the S&P 500 is once again pushing all-time highs.
We can drill down even further now and see that small-cap stocks in general have completed a 10% correction. The Russell 2000 small-cap index has broken below its 200-day moving average.
This is significant for a couple of reasons…
First of all, small-cap stocks are often considered to be measures of sentiment, especially in the later stages of a bull market. The idea is that as investors get more comfortable with a bull market, they take on more risk. Investors looking for more action start plowing into speculative small-cap stocks.
That’s why the Russell 2000 put up a 36% gain in 2013, while the S&P 500 “only” managed a 30% advance.
So, when small caps start selling off, investors usually expect to see the selling spread to the large caps. Only that still hasn’t happened.
The question now, with small-cap stocks flirting with bear market territory, is: will this selling spread?
One analyst, who writes the Irrelevant Investor blog (theirrelevantinvestor.tumblr.com), noted that the Russell 2000 has made a 10% decline 35 times since 2000. And every single time, the S&P 500 has followed with a 10% decline of its own.
This is the 36th time small caps have dropped 10%. And this time, the S&P 500 is not showing any signs of a big decline.
What’s going on? Have investors actually managed to act rationally and take some of the fluff out of the most overvalued sectors of the stock market while leaving reasonably valued stock alone?
Valuations and Dividends
Two things stand out to me concerning the divergence between small- and large-cap stocks.
The first is valuation. The trailing P/E for the Russell 2000 had risen well above 20. And momentum stocks have far more ridiculous valuations, as we’ve discussed.
But looking at the S&P 500, the trailing number stayed around 18.
Then there’s the question of dividends. For this, we will have a look at the Russell 1000, and we will thank Bespoke Investments for this analysis.
The Russell 1000 index approximates the 1,000 largest U.S. companies.
300 of the companies in the Russell 1000 pay no dividends at all. As a group, these stocks are down 7.2% since March 5.
But the top 300 dividend stocks on the Russell 1000 are up 2.1%.
We see the same trend in The Wealth Advisory’s portfolio.
A few stocks have sold off a bit, like Bank of America, Pfizer, and Triangle Capital. But our REITs have been essentially untouched by the controlled burn. And dividend growers like Banco Santander and Boeing have rallied nicely.
This is a great example of the power of dividend stocks.
It’s also telling about sentiment in the market…
It would seem that investors are very conscious of valuation. High-valuation momentum names have sold off. Reasonably valued income stocks have been stable.
The lesson is simple: own quality dividend-paying stocks and make more money.
Controlled burn, indeed…
Until next time,
Until next time,
Briton Ryle
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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.
