When markets rotate, sometimes they can over-rotate to extreme levels. It’s off-putting for rational investors, but this is when great opportunities arrive at your doorstep.

Lately, the balance between momentum stocks and value stocks has gotten completely out of whack. Until the FOMC day debacle, the risk-on trade was in full effect and “Magnificent Seven” technology stocks kept on hitting new all-time highs.

It all came crashing down when the Federal Reserve’s dot plot revealed that the central bank only expects to cut interest rates twice next year instead of the assumed four rate cuts. With that revelation, the tech-focused NASDAQ led the way down amid a sea of red.

That was just one day, though, and it’s not enough to establish a pattern or a trend. Until proven otherwise, the market still overwhelmingly favors momentum stocks and dislikes value stocks.

This helps to explain why the NASDAQ has so strongly outperformed the Dow Jones Industrial Average recently. Unlike the NASDAQ, the Dow is a more balanced and diversified index with some decent values outside of the technology sector.

Courtesy: BarChart

Index fund investors felt like they were missing out on the huge gains in the NASDAQ – a classic case of FOMO (fear of missing out). They felt the need to pull cash from somewhere to buy mega-cap technology stocks, so they liquidated their Dow holdings.

Courtesy: BarChart

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    Note, by the way, that they also cashed out their value stocks. If you understand the principles of market rotation, you can use charts like this to see exactly what’s happening and where the money is flowing.

    In times like this, it may be tempting to throw your copy of Benjamin Graham’s The Intelligent Investor in the trash can. You might decide that Warren Buffet is out of touch with modern investing and price-to-earnings (P/E) ratios are irrelevant in the 2020s.

    Alternatively, you can take advantage of amateur investors’ feelings of FOMO. Notably, the FOMC day collapse of “Magnificent Seven” stocks provided a glimpse of how quickly these stocks can turn south when the momentum runs out.

    I’m not suggesting that anyone should short-sell “Magnificent Seven” stocks. Rather, I’m looking at the opportunity to buy value stocks at depressed levels when compared to the rest of the market.

    How depressed? Amazingly, value stocks the cheapest relative to growth stocks since the 2000 dot-com bubble. Over the last 15 years, believe it or not, value stocks are up 363% but growth stocks are up by a whopping 907%.

    Courtesy: @KobeissiLetter

    Perhaps it takes a value investor’s mindset to appreciate the opportunity here. When value stocks are lagging so much behind growth/momentum stocks, a contrarian investor will naturally anticipate a rotation back to the best values.

    The problem is that it’s not easy to predict when this will occur. If you get into value stocks too early, you’ll risk steep losses before the counter-rotation finally occurs.

    That’s why scaling into positions gradually is so important. You’d need perfect timing if you throw all of your investable capital into value stocks all at once, which I don’t recommend.

    Also, it’s crucial to define what a good value is. It’s worthwhile to look up P/E ratios, but they’re not the be-all and end-all when it comes to value.

    And as the old Warren Buffett saying goes, price is what you pay but value is what you get. So, don’t just assume a stock is a good value just because the price went down. Conduct your full due diligence, think in terms of owning businesses instead of just owning stocks, and know that valuations always matter sooner or later.

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