Investors Are Getting Scared. How to Use That to Your Advantage. – Barron’s

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The current second-quarter earnings season feels like a game of Russian roulette. Each major company report has the potential to sway investor sentiment, which is already shaky. Theres a sense a sea change has begunone that could change the assumptions that have supported the stock market for the past 12 years.

Federal Reserve Chairman Jerome Powell told Congress this past week that the central banks easy-money policies were unlikely to change soon. Investors are adopting a trust-but-verify approach.

This level of skepticism has rarely been seen since the tense hours of the 2007-09 financial crisis, when earnings reports were highly valued because they offered investors a chance to use corporate data to verify what government officials were saying.

Now, like then, there is a lot to verify, especially about inflation, which the Fed contends is transitory even if it is at the highest level in more than a decade. The mismatch likely explains why many investors have hedged their stock portfolios at the onset of earnings season.

Moreover, the benchmark indexes are increasingly dominated by a small group of stocks, which might be masking problems, Steve Sosnick, the chief strategist at Interactive Brokers, tells Barrons.

Narrowing leadership often leads to trouble, because if something induces people to lighten positions, you will have a lot of people trying to squeeze through the small door of those stocks that they bought on the way up, he says.

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Investors, in turn, are buying more put options, which increase in value when stock prices tumblea move that has attracted a lot of attention because it has historically been a money-losing decision for as long as the so-called Fed put has existed. Stock prices have almost continually advanced since 2009 because the Feds policies have kept stock prices aloft.

While hedging makes some sense, it is perhaps better to be opportunistically patient. Compile a list of equities to buy, or buy more of, and wait for the chaos that could be triggered by a surprise earnings report.

For clues, watch the Cboe Volatility Index, or VIX. The fear gauge is still relatively sanguine at just over 16. Should it spike into the high 20s or low 30s, it may mark a good time to buy quality stocks that you can hold for a few years. There is nothing profound in this simple approach, but it often works.

Extreme fear distorts prices and leads people to make bad decisions. If you have a plan to buy stocks, anything that scares others is an opportunity. If that dark day never comes, at least it provides a way to sort through all the palaver that surrounds the stock market.

Everyone will have their own preferred way of monetizing fear. Some sell puts in the middle of a maelstrom. Others buy stocks and even sell call options at the same time. There is no right way. The key is using fear as an ally to buy well-run companies like PepsiCo (ticker: PEP), which just reported good earnings and increased its 2021 earnings forecast, or to position in controversial stocks with intriguing prospects, like Tesla (TSLA).

The wild card remains the Fed. It has been a long time since interest ratesand the cost of capitalwerent low. Under those conditions, it makes sense to seek returns among riskier assets. An entire generation of investors knows nothing but low rates, and risk takers have often grown rich.

The current risks of rising rates and inflation are real. But the strategy of buying blue-chip stocks that pay dividends, and holding them in ones portfolio for years as returns and dividends compound, is a battle-tested approach.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.

Email: editors@barrons.com

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Investors Are Getting Scared. How to Use That to Your Advantage. - Barron's