The Two Best Performing Stock Groups After A Correction

I don’t know if the current correction is over. What most of us know is that stock indexes hit their momentum lows on January 20th and they have been in an extremely choppy, back-and-forth environment ever since. This is a normal price action after big and fast drops. If past history is a good guidance, we are very likely to see a re-test of the momentum lows at some point. If the test comes with some form of breadth divergence – for example, a smaller number of stocks making new 50-day lows compared to Jan 20 or smaller number of stocks dropping below their 50dma, and we see heavy institutional buying, then we might have a major sign of a bottom. Remember, bottoms are formed by heavy buying, not heavy selling (even though the latter often happens first).

The more interesting question here is, what are the best-performing stocks after a deep market correction?

1. The ones that sold off the most during the correction. Many of them are priced for bankruptcy. The moment the market realizes that it is not likely to happen, we could see some extreme moves in those stocks. And by extreme, I mean 100% to 300% moves in 2-8 weeks. In the current environment, these are oil & gas, steel stocks, emerging markets.

2. Growth stocks that held the best during the correction. Growth stocks are usually high-beta names that get hit pretty hard in times of market panic. If any of them manage to hold above their 50-day moving average, build a new base or even attempt to make a new 52-week high during the correction, they will likely outperform significantly during any bounce attempt. Note that I accentuate Growth. During corrections is normal to see low-beta, high-yield groups like utilities and consumer staples to hold better than the rest of the market, but they are not going to outperform during a market recovery.

Keep in mind that there are different types of corrections. In a garden-variety 5-10% pullback above a rising 200-day moving average, momentum stocks with the highest relative strength during the correction are likely to significantly outperform during a recovery. After a deep >20% correction below a flat or declining 200dma and especially after a long bear market, many of the best performers will come from the most beaten down stocks that were priced for bankruptcy, but managed to survive.

Some corrections turn into bear markets. They are rare, but they happen. Bull markets reward risk-taking, but when the bear puts out honey, he is usually laying a trap. In bear markets, you buy when the fear of losing is very high and you sell when the fear of missing out is very high. As usual, easier said than done.

One Setup that Is Currently Working Well

2016 started with a major selloff during which most equities were highly positively correlated. In other words, most stocks moved together in the same direction – up and down, regardless of individual merits. This is a typical price behavior in times of panic and the ensuing bounces from oversold breadth levels. It is also one of the main reasons many people focus on trading high-beta ETFs in times of unusually high volatility.

As volatility subsided in the past couple weeks, correlations dropped and stock picking started to matter again. Stocks that beat earnings estimates and initially received favorable market reaction started to outperform. Academicians have named this process P.E.A.D. or Post Earnings Announcement Drift – stocks that gap up on a better than expected earnings report, tend to drift higher for several days to several weeks; stocks that gap down, tend to drift lower.

This is not just a temporary phenomena. It could be observed and traded successfully almost every earnings season by traders with various time frames – intraday, swing and position trading.

Here are some examples from the past couple of weeks.

Positive Market Reactions:


Negative Market Reactions:


Why do stocks continue to drift in the direction of the initial market reaction?

There are two plausible reasons:

  1. People tend to under-react to new information, then they panic (either because of fear of missing out or fear of losing) and over-react.
  2. Institutions need more time to build a new position or to distribute an existing one.