Two Shining Opportunities in Today's Fear-Driven Market

AdamDo you feel like there’s been no place to hide in 2016!?

The S&P 500 is down 11%. Eight of its nine sectors are firmly in the red. And two-thirds of individual stocks have already slipped into a bear market.

As the list of stocks hitting new lows grows by the day, the smell of fear in investor’s behavior is getting stronger and stronger. And that means panic behavior might be just around the cornrner.

So today I want to show you how to profit from fear and panic, rather than succumb to it.

I want to show you how to rise above the “caveman mentality” that stands between you and investing success.

You see, individuals tend to mimic the actions of those around us… even when those actions are irrational or in direct conflict with our best interests.

This “herding” phenomenon is precisely what sends financial markets into bubble territory, with historical examples dating as far back as the infamous tulip mania bubble in 1637.

But there’s a more subtle aspect to the herding phenomenon that often goes unnoticed…

It’s a phenomenon I call “scatter fear.”

And by detecting this fear among investors, I was able to identify two of the year’s top-performing investments by mid-January – the only stock market sector in the green so far and a bond market that hit new highs just yesterday.

So let me tell you about “scatter fear,” which really just comes down to one thing…

And that’s human nature.

The herd mentality and herding behavior exist because human beings are hard-wired to stick close to the group.

In caveman days, individuals who lumped themselves in with the group were better protected from predators than those who boldly struck out on their own. Over time, more of the “I’m-with-the-group” individuals survived and reproduced than those of the “I’m-on-my-own” kind.

That’s why, even in today’s supposedly civilized society, we’re conditioned to find safety and comfort in the group. And the tighter, more close-knit that group is… the safer we feel.

Interestingly, I’ve found threads of this hard-wired behavioral phenomenon in my research into stock market sectors – the main focus of my trading service, Cycle 9 Alert.

Over the years, I noticed that individual stock sectors move in a tight-knit, herd-like fashion some of the time. Other times, individual sectors “scatter” from the herd… meaning some sectors perform very strongly, while other sectors perform very poorly.

After thinking about this for a while, and meshing it with what I know about human behavior, I came up with a hypothesis: investors are probably most nervous when individual stocks are “scattering”… more so than when everything’s herding.

Think about it…

You wouldn’t worry too much to hear that the nine market sectors had returnrned between 5% and 10% over the last quarter (a 5% spread – low divergence).

But wouldn’t it make you scratch your head if the nine market sectors had returnrned between -10% and positive 15% over the last quarter (a 25% spread – high divergence)!?

So I did some research and I found that during periods of high divergence, when the sectors are scattering… defensive, “risk-off” assets tend to outperform aggressive, “risk-on” assets.

This shows that investors are indeed most nervous during high-divergence (scattering) periods. And that’s because sector scattering feels scary… and sector herding feels safe.

Just take a look at the results of my research…

Annual Rate of Outperformance During Periods of High Divergence

Clearly, “risk-off” markets perform better during periods of high divergence. By “high divergence,” I’m referring to any point when the spread between the top and bottom sectors is 16% or more. Sometimes it’s as low as 7%, other times it’s higher than 40%. But 16% is right in the middle, so I consider anything above that to be high divergence.

As you can see, during periods of high divergence (scattering), the safest sector of the stock market, the utilities sector (XLU), earnrns an annualized rate of outperformance of 9.6%. And the safest bond markets – U.S. Treasuries (TLT and IEF) and municipal bonds (MUB) – earnrn an annualized rate of outperformance, averaging 3.2%.

And on the other side of the coin, “risk-on” markets, such as high-yield junk bonds (JNK) and the S&P 500 (SPY), underperform to the tune of 2.9% and 3.6%, annualized.

The actionable opportunity here is simple…

Invest in utilities stocks and high-quality U.S. bond markets when divergence is high (above 16%). And avoid high risk markets, like junk bonds and stocks.

Pretty interesting, right?

But this research isn’t just hypothetical. I actually used it to point Cycle 9 Alert subscribers into two top-performing “risk-off” markets in mid-January… just as we entered a high divergence environment.

Specifically, on January 19, I told them to make a bullish play on the SPDR Utilities Sector ETF (NYSE: XLU) and the iShares Municipal Bond ETF (NYSE: MUB).

And so far these have been doing quite well for us.

In just under a month, we locked in a partial profit of 61% on one of these positions. And the other one is currently up 22%… and it just hit a new high yesterday!

Even though those are great returnrns in just three weeks’ time, I still think both of these risk-off markets are poised to outperform for a while longer… so there’s still time to get in.

Adam O’Dell, CMT

Chief Investment Strategist, Dent Research