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Fundamentally Strong Stocks Will Prevail in a Correction

NEW YORK (TheStreet) -- The market has been in a correction mode over the last few weeks. The Nasdaq Composite is down 2.4% in the year to date while the Nasdaq Internet index has lost 6.62% over the same period. Clearly, tech and Internet companies have been hit harder than the broader markets.

The last few years have seen stock prices largely driven by metrics other than earnings. While some have seen stock gains on account of acceptable metrics like revenue growth, some of the tech stocks have been irrationally fuelled by metrics like number of unique visitors.

Establishing a fundamental relationship between these metrics and stock prices is something that is impossible. These are more or less what we call momentum stocks, driven by euphoria combined with metrics that make little financial sense. These are stocks that are clearly cut off from their fundamentals.

Momentum stocks trade with the broader markets, returning insanely high returns in good times but can wipe out these returns and even more during a correction/pullback.

On the other hand, there have been companies that havent netted investors returns of the scale momentum stocks have managed but have closely traded in relation to their fundamentals. These are what we call high value stocks. The table below compares the 2014 year-to-date performance of some well-known stocks and indexes.

The markets today are on the edge from where they could fall hugely. One of the best indicators of overvalued markets, the Warren Buffett indicator, indicates a solid case of overvalued markets. The indicator looks at the market cap to GNP ratio in order to understand the valuations levels of the overall markets. The U.S. GNP for the fourth quarter of 2013 was reported as $16.188 trillion.

The total market capitalization of stocks listed on U.S. exchanges was $24.85 trillion at the end of February 2014, as reported by the World Federation of Exchanges. Adjusting the total market cap for the S&Ps movement since the end of March 2014 (-2.25%), we get current total market capitalization of $24.29 trillion. The total market cap to GNP ratio, as per our estimates, is 1.50.

According to Buffett, any level greater than 1 is a case of modestly overvalued markets while anything closer to 2 is highly dangerous. At 1.5, the markets are significantly overvalued and a correction is likely. On a comparative note, the total market cap to GNP ratio in October 2007, the peak before the 2008 crash was 1.36, which is significantly lower than where the markets stand today.

The markets are trading at multiples more or less in line with the pre-2008 crash. A comparison of the valuation multiples in January 2008 (just before the crash) and estimates as of today highlight the risk associated with the equity markets at the current valuation multiples. The S&P 500 today trades at a price-to-sales (P/S) multiple of 1.63 against 1.43 in Jan 2008.

The markets today are at a point where the underside risk far outweighs the upside potential. The current correction in the markets will most likely continue until a favourable risk/return level is reached. In the falling markets, fundamentally strong stocks have a far higher chance to outperform the broader markets.

Hence, investors would be better off staying invested in fundamentally solid companies with strong cash flow abilities rather than growth names or momentum stocks.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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