The big drop that we have seen over the last week and a half or so started logically enough. Treasury yields, which drive interest rates in the broader market, were climbing and the Fed was making hawkish noises, pointing to an ever-tighter labor market and data that were hinting at the nascent inflation that the market was presumably discounting.
By the middle of the week, however, it became clear that we had moved beyond logic. Fear and emotion were driving stocks down past the point of reason, and it was time to consider buying. We could yet see more volatility this week, but early indications this morning are that we will start with a bounce, so investors should have a plan as to what they are going to buy.
As usual when faced with that question, the first thing to decide is what not to buy. After a big move, the logical place to look is in the hardest hit sectors, but in this case, neither of the two worst performing S&P sectors, neither energy nor financials, have any appeal.
Energy stocks are driven largely by the price of oil, and while WTI (the U.S. benchmark crude) has been tracking the stock market to some extent based on the prospect of lower growth, that has been in the context of a longer-term decline based on supply rather than demand. A couple of weeks ago, crude oil was trading in the high $60s, which represented multi-year highs. As the price rose, though, so did U.S. production, and that had started to put downward pressure on crude.
The jury is still out on whether that will continue for any meaningful time, but the point here is to buy stocks that will bounce back quickly with the market. Why buy something that, because of other factors, may not?
The same applies to the second-worst performing sector last week, financials, but for a different reason. In this case, the thing that spooked the stock market, higher interest rates, hurts not just the prospects for stocks in the sector, but also their current value. Higher rates mean lower bond prices and large financial institutions typically hold a lot of bonds, particularly Treasuries that are deemed risk-free assets. As bonds drop in price, therefore, so the value of financial stocks decreases along with them.
So, if neither energy nor financials make sense, where should investors be looking?
The answer lies in two sectors that were in the middle of the pack in terms of losses last week, tech and industrials. In the tech sector you do not need to take on a lot of risk to benefit from the bounce, so solid, old tech companies are preferable. Both Cisco Systems (CSCO) and Microsoft (MSFT) have recently revamped their businesses, and a strong case can be made that as a result, both were undervalued even before the drop. That makes them bargains now after declining along with everything else.
Being cheap isn’t everything, though. There must also be an expectation of future growth, even if rates do rise and temporarily slow progress here in the U.S. Both CSCO and MSFT have huge international divisions, and that gives them some protection. Even if there are questions about the U.S., global growth predictions continue on an upward path, and both companies are positioned to benefit from that.
That same logic, along with one other factor, applies to my pick in industrials, Boeing (BA). According to the company's website, around seventy percent of their current order backlog is from international customers, so relative weakness in America would not hurt them as much as it would some. That said, though, North America is still Boeing’s largest single region in terms of sales, but much of that revenue is not vulnerable if overall growth slows.
That is the money that comes from defense contracting. That is an area that looks likely to grow over the next few years, almost regardless of what happens in the economy. Even as the current Congress adds massive amounts to projected deficits, the one area that seems to gain general support is increased defense spending. With a President who is under pressure in other areas and relies heavily on retired military personnel for advice, that isn’t going to change because of a lead from the executive branch either, so for Boeing and others in that business, the gravy train therefore not only continues, but is gathering pace.
We are at the point now where “buy the dips” is not enough. Investors need to have a clear idea of stocks to buy that will bounce back, have some protection in the near future if volatility continues, and have good prospects regardless of where U.S. rates end up. MSFT, CSCO and BA check all three of those boxes, so should be at the top of your shopping list at this point.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.