Last week was not a great week for the stock market -- the Dow Jones Industrials dropped 507 points (3.9%) and the S&P fell 49 (3.5%). After a strong climb from the March lows, the market seems to have reversed. Was this simply a bull market correction, exacerbated by the release of the FOMC minutes and the surge in oil prices, or the end of a bear market rally and we will now resume a downward trend?
Not surprisingly, I do not know the answer. If I had to pick, I would lean towards this being a correction, but I am far from certain. I am fairly confident, however, in three points... First, there is more economic pain to come -- housing, credit, and energy prices, among other factors, will continue to weigh on the economy and impact consumer confidence. Second, equity prices, especially for the investment banks, have discounted much, though likely not all, of this bad news. Third, growth in emerging economies, especially in Asia, will remain a substantial driver of overall global growth and continue to fuel demand for energy, foodstuffs, and raw materials.
So, as we go into the summer, my investment themes are focused on companies with attractive valuations in global growth plays -- infrastructure, energy, raw materials, and foodstuffs. Though I am not bearish enough at this point to short stocks in the weaker sectors, such as financials and consumer discretionaries, I will avoid taking any long positions.
In my view, the best possibilities remain in the materials sector. As reflected in the XLB, basic materials have had a good run since their early January lows, though they have sold off in the past week. Nonetheless, long-term growth trends, especially in Asia, will keep pressure on raw materials prices and continue to produce handsome returns for firms in that sector. Companhia Vale (RIO) has long been one of my favorites and is a long-time holding which I believe will continue to do well. Rio Tinto (RTP) and BHP Billiton (BHP) are also good choices. Steel companies such as Arcelor Mittal (MT) should continue to do well. Demand for grains -- for food, feed, and fuel -- will be supportive of fertilizer companies, though many of these sell at fairly rich valuations already.
The global growth argument is equally applicable to the energy sector, represented by the XLE, which has had a similar, though slightly better, track record than the XLB since the start of this year. Within this sector, oil services firms offer the best opportunities. Regardless of sometimes volatile fluctuations in the price of oil, the demand for energy will doubtless continue to increase and there is a growing sense of urgency to find and exploit new reserves, making drillers such as Transocean (RIG), Atwood Oceanics (ATW), and others attractive plays. Domestic natural gas plays, as an alternative to oil, are also interesting.
For the time being, I have decided to mostly stay away from financials (XLF) and consumer discretionaries (XLY). Doubts about the full impact of the credit crunch on financial markets linger, and even though I think that most of this has been priced into the financials (especially investment banks), too much uncertainty remains. This could be a recipe for good returns if one times things correctly, but there are better risk-reward ratios to be found elsewhere.
Additionally, continued bad news on the housing, food, and energy fronts continues to pound on consumer sentiment, which does not bode well for the consumer discretionary sector, especially the retailers, in the near-term. After a rally in early May, this sector has dropped under the impact of all this news. It is too early, in my opinion, to buy for the rebound.