Everything’s down, but discriminating among equity sectors still has its merits. In fact, one could reason that selectivity becomes that much more critical if the downturn in the stock market is more than just a temporary setback. Genius is a bull market, an observation that’s delivered no small advantage in recent years. But an eye for finding pearls among swine may be due for a comeback as a favored investment skill.
As you might expect, the broad-based selling of late has dispensed varying degrees of red ink across the ten major sectors that comprise the S&P 500, as the chart below illustrates. So far in May, information technology has suffered the biggest loss, tumbling 7% this month through last night’s close, according to Standard & Poor’s. The relatively conservative utilities, by contrast, have been pinched the least, posting a stumble of just two-tenths-of-one-percent. Overall, the stock market (measured by the S&P 500) has shed 2.5% in May.

In the search for investment justice, some may look for signs that the highest flyers of the large-cap equity sectors so far this year have taken the toughest punishment this month. But the record is mixed on that score. Indeed, the worst-performing sector (information tech) in May is also the big loser year to date through yesterday. Meanwhile, the second-biggest year-to-date winner–industrials–has endured one of the milder sell offs so far this month.
Justice, such as it is, is most obvious among the energy stocks. As the leading performing sector in 2006, energy has taken one of the sharper tumbles in May, falling 5.7% so far this month.

And what of financials? By far the largest sector in the S&P 500, measured by market cap, financials would seem to be particularly vulnerable at the moment. Indeed, with renewed inflation fears, the threat of still-higher interest rates loom. If history is a guide, that’s bad news for companies that thrive on cheap money and robust demand for borrowing.
But if you’re expecting clear signs of pain in the financial stocks, you may be disappointed to learn how the red ink has been allocated so far this month. Yes, financials have taken it on the chin in May, descending by nearly 4.3% through yesterday. But that loss, painful as it is, has been exceeded by energy, materials and info tech. In fact, despite this month’s sell off, financials are still up by more than 2% on the year.
Meanwhile, BCA Research thinks financials will shine once more. “Inflation fears continue to dominate investor emotions, which suggests more near-term downside in financial stocks,” BCA advised yesterday. “However, we eventually expect to step into this weakness, and boost weightings in the capital market group.”
BCA’s reasoning is that renewed anxiety over inflation will be temporary once the economic slowdown that many expect arrives in earnest. Slower growth equates to a lessening of inflationary pressures, in other words. At that point, a buying opportunity will arrive for financials. “The past few years have shown that after inflation expectations (derived from the TIPS market) have rolled over, capital market stocks soon bottom owing to the inevitable upturn in risk appetites and corporate animal spirits.”
Perhaps. But getting from here to there requires crossing what could be some volatile market terrain as investors the world over rethink assumptions about future risk and return. As such, the bulls find themselves on the defensive for the moment. If the current climate proves to be a transition point, increased volatility in the bond and stock markets could be the norm for some time.
The VIX index, a measure of price volatility for the S&P 500 based on options prices, has in fact spiked upward of late, reaching its highest level in more than a year. “The risks are high as the uncertainty around interest rates remains unclear,” Herb Kurlan, president of Vtrader Pro, an online trading firm, told Reuters yesterday. “So investors are scrambling to buy puts to lock in any remaining gains they have from the Spring rally.”
Optimists point out that sudden, sharp upturns in the VIX have signaled an end to the selling, at least for a time. On the other hand, bottoms in stock slumps are clear only in hindsight, and so the jump in VIX could signal more pain ahead.
For those with a longer-term outlook, the current dip in stock prices may be too enticing to pass up. “One of the main reasons I remain optimistic, despite the recent carnage in global stock markets and commodity markets, is that corporate profits remain extraordinarily strong,” writes Ed Yardeni, chief investment strategist at Oak Associates in an email to clients this morning. He reports that forward earnings for stocks across the capitalization spectrum–S&P 500, 400 and 600, or large-, mid- and small-caps, respectively–continue to “soar to new highs” as of May 19. “This suggests,” he continues,

that notwithstanding the weakness in housing, the overall economy remains amazingly resilient. The recent sell offs in U.S. stocks was purely a P/E [price-earnings ratio] event. Valuations are even more attractive now, especially given the bullet-proof performance of earnings. Large-cap stocks are cheaper than small-caps, and could outperform as investors seek safety in Blue Chips. However, don’t underestimate the power of small-caps to recover smartly from the recent nasty correction based on high-flying earnings. The fact remains that investors around the world have huge sums of money to invest.