The markets were all set to open on a strong note this morning following the release of more favorable short term inflation data, but quickly plunged almost 3% following news that Bear Stearns is at risk of going out of business.  At this time, Bear Stearn’s stock is down 42%.  The markets have recovered somewhat from their lows, but are still off about 1.5% as we write.  While we would point out that almost all market crashes and recessions have been accompanied by some type of high profile banking failure, that recognition doesn’t always sit well when bullets are flying overhead and you’re not sure if you’ll be a survivor or casualty.

So, the question is, “What’s an Investor to Do?”

As we see it, the two known problems facing the stock market are and have been:

        1.) The troubled credit markets and,
        2.) The slowing U.S. economy.

All areas tend to do poorly during periods of extreme uncertainly like we are experiencing today.  Once the dust settles, however, new leadership areas usually emerge.  To put it simply, if the credit markets are troubled and the U.S. economy is slowing, you should prefer:

        1.) Companies and industries that don’t depend on the credit markets as a primary source of cash flow and
        2.) Companies and industries whose success is less exposed to a slowing domestic economy.  

More specifically, we’d focus on technology and health care related technology plays where innovation rates are very high and competition is relatively low.  In general, innovative companies rely less on the ebbs and flows of the economic cycle for their success and more on entirely new and emerging classes of products.  In addition, they typically generate lots of cash from their own operations and thus are less dependent on the credit markets to fund future near and intermediate term growth goals.

We would also focus on multinational industrials that stand to benefit from continued cycle-driven growth in overseas economies, with one caveat.  We would be careful with commodities.  While we understand the global drivers behind longer term moves and do believe that these products represent the innovation in these economies, we think the latest upswing reeks of rampant speculation not too dissimilar from the private equity craze one year ago, the homebuilding craze a few years ago and the technology craze nearly eight years ago.  We do not believe that foreign world economies have completely decoupled from a slowing U.S. economy, which could eventually be the catalyst that pricks this current bubble.  In the past few weeks, we’ve taken a close look at the historical correlation of stock prices in our portfolio to the prices of commodities like oil, seeking to more clearly understand our exposure.  We’d recommend investors do the same. 

Moving on, we would continue to avoid the financial services sector.  While it will enjoy many strong bounces, they will likely be of the bear market variety in the coming quarters rather than the beginning of a new bull market.  It is very rare for areas that were at the center of a bubble that bursts to likewise lead us out of the resulting mess.  At the end of the day, most financial services companies are cyclicals that almost always find themselves in a heap of trouble once every ten years or so.  This is why investors rarely, if ever, pay even a market multiple for their earnings no matter how high they climb.   There will be a time to load up on the financials, to be sure, but for now, we’d keep our powder dry.

On the other hand, from a contrarian perspective, we are starting to tip toe into a number of consumer discretionary names.  This sector has suffered almost as much as the financial services sector and yet, with the exception the homebuilders, it hasn’t been battered by many fundamental disasters.  Historically, this sector has done very well as we emerge from Fed easing cycles and recessions and we would expect this trend to play out this time as well.  We’d focus on consumer discretionary companies with strong brand names, innovative product cycles, and international consumer appeal.  At the same time, we would continue to be suspicious of anything housing related.

As the current financial storm reaches its peak intensity, we think investors should start planning for the calmer days ahead.  If history is a guide, it’s unlikely that we’ll emerge from this storm on the same boat we entered it.

But emerge, we will.