Stocks: How Investors Might Play the Pullback

With stock markets quaking around the world, commodities prices tumbling, and trouble in Europe's sovereign debt markets spreading fear of contagion, it's fair to wonder if a new bear market is in the offing. After careful thought and deep breathing, however, investors are more likely to remember that corrections are an inevitable part of market activity. After a 72% rally that spanned more than 10 months, U.S. stocks were long overdue for a pullback.

The Standard & Poor's 500-stock index peaked on Jan. 19, closing at 1,150.23. In 13 subsequent trading days, it fell 7.3% to finish at 1,066.18 on Feb. 5. The Dow Jones industrial average, after breaking below the 10,000 level on Feb. 4 and Feb. 5, bounced back to close at 10,012.23 on Feb. 5, down 7.1% from the end-of-day top of 10,725.43 it registered on Jan. 19.

For investors who sat out the 2009 rally and have been bemoaning that they missed what some called once-in-a-lifetime bargains, the sharp pullback should be a welcome buying opportunity. How many people view it that way?

"[The U.S. stock] market has averaged a 10% correction once a year for 100 years. Is it realistic to believe we could [avoid] a 10% correction after the run-up we've had?" asks Alan Skrainka, chief market strategist at Edward Jones in St. Louis. "People need to stay calm, stay invested, and stay focused on their long-term goals."

Fears that Greece and Spain might default on their debt garnered most of the attention last week, but market strategists think the stock market's woes began Jan. 12, when the Chinese government ordered state-owned banks to set aside bigger reserves to cover potentially failing loans and to tighten their lending standards.

dialing back on excessive optimism

China's stock market was the first to break below both its 50-day and 200-day moving averages on technical trading charts, Liz Ann Sonders, chief investment strategist at Charles Schwab (SCHW), points out. "China was viewed as the growth engine of the [global] economy. When monetary authorities needed to step in to rein in liquidity, it sent a message that the poster child for the recovery [may be] stumbling a little bit."

The market had to dial back the excessive optimism that had taken hold in recent weeks, she says.

Recent sentiment surveys still show enormous sensitivity among investors. "I don't view that as necessarily bad," Sonders says. "If we were in an environment where you couldn't do anything to pull back the optimism, that would be more troubling."

David Joy, chief market strategist at RiverSource Investments (AMP), agrees that the pullback is positive to the extent that it scares some "hot money"—speculation—out of the market. "It's a healthy development," He says. "It [signals] an adjustment process to a more mature phase of the recovery."

Rob Lutts, president and chief investment officer at Cabot Money Management, is confident that the correction can be contained. He cites a very accommodative Federal Reserve and Treasury Dept., both committed to doing whatever is needed to restart the economy. He also points to improving manufacturing and service sector data in recent weeks. Most important, Lutts says, is an estimated $3.2 trillion in cash on waiting to be deployed.

technical test at 1,035 on S&P 500?

A more likely source of cash to get stocks rallying again is all the money that's accrued in the debt market over the past year, Treasury bonds in particular could flow into equities if yields start to rise, says Sonders at Schwab. (Bond prices fall when yields rise.)

The stock market may need to correct as much as 10% to 15% before it's clear how successful China's liquidity withdrawal efforts have been at slowing the country's pace of economic growth, says Joy at RiverSource. He's expecting a 10% correction that leads to a test of 1,035 on the S&P 500 index, a key technical support level.

Joy says that if the market can hold 1,035, the correction might stop there. He won't be surprised, however, if the market breaks below that level, for a total pullback of about 15%.

Where then, lie the most attractive stocks while the market is in retreat?

The hardest-hit stocks that still represent ongoing value are in the materials sector, says Joy. "I still believe infrastructure will be a successful and prolonged strategy [for most countries' economic development], and you need materials to accomplish that."

The bellwether material is copper, which has shown the most sensitivity and reacted most visibly to worries about how China's reversal of liquidity measures will affect economic growth, he says. Shares of Freeport-McMoRan Copper (FCX) peaked at 88.10 on Jan. 8 and have fallen 18.5% since Jan. 13, the day after China's loan tightening order. An expected slowdown in China's economy is presumably the main reason that commodities prices have plunged in recent weeks. That's reflected in shares of aluminum producer Alcoa, too, Joy says. Alcoa's stock peaked at 17.45 on Jan. 11 and is down 17.5% since Jan. 13.

Schwab likes the health-care sector

Industrial stocks haven't corrected as much as materials, but they will also be in demand as the economic recovery proceeds, says Joy.

Two weeks ago, Schwab downgraded its view on the technology sector to market perform, from outperform, deciding it was time to take profits on the equities rally's hottest sector. The nearly universally positive sentiment toward technology was mostly predicated on companies' prospects for earnings growth, which remain intact, says Sonders. She believes that analysts' expectations for tech earnings simply rose too high. "In this correction, technology has really taken it on the chin."

Schwab raised its rating on the health-care industry to outperform, from market perform, on a combination of more attractive stock valuations and ebbing concern about the market impact of Washington's health-care reform efforts. "The uncertainty somewhat lifted when health reform, as we knew it several weeks ago, died with the Massachusetts election," she says. "[The reform bill] is still in play, but it's less likely to pass in its form of several weeks ago."

Otherwise, Schwab is taking a neutral view of all but one sector: Consumer discretionary is the only sector Schwab rates to underperform.

PNC Wealth Management (PNC) in Philadelphia isn't adjusting its portfolio allocations in response to the pullback. In general, the firm's portfolios remain slightly overweighted toward cyclical sectors. Its biggest overweight allocation is in technology and it also has a fairly substantial overweight position in industrials. Lutts at Cabot likes such technology names as DragonWave (DRWI), which provides wireless Ethernet equipment and stands to benefit from the buildout of infrastructure needed to accommodate more bandwidth-intensive wireless traffic in the years ahead. DragonWave's revenue is growing at 60% to 70% a year and Lutts believes it will continue to grow at that rate for a few more years.

Dollar strength, foreign bargains

Bill Stone, PNC's chief investment strategist, sees some opportunities developing in health care, which he doesn't regard as a cyclical play. Early last week, PNC added to its holdings of Covidien (COV), the Dublin-based provider of medical devices, diagnostic imaging products, and pharmaceuticals that was spun off from Tyco International (TYC) in June 2007. Covidien's management believes margin expansion is sustainable and will drive future earnings. In addition, the company has some new pain medications coming to market, says Stone.

PNC's portfolios have about a 20% weight in international stocks, which should be relatively cheap while the dollar stays strong.

Edward Jones generally recommends a 65/35 split between stocks and fixed income, with 25% of the equity portion allocated to non-U.S. stocks. But Skrainka warns investors to be careful about emerging markets for a time and to keep that allocation below 5% of their total portfolio. Over short periods of time, there's no proven relationship between a country's rapid economic growth and high returns in its stock market, he says. "That's because in many cases this rapid expected growth is already priced in [to stocks]," he says. Skrainka prefers developed foreign markets and recommends using mutual funds rather than individual stocks to gain exposure to them.

Lutts at Cabot is more optimistic about emerging markets than most other pros, pointing to attractive stock valuations in China, India, and Brazil. He recently bought shares of International (CTRP), a Shanghai-based online travel company whose price is down 8% since Feb. 2, when fourth-quarter earnings missed analysts' forecasts. Ctrip is growing its revenue at 30% to 40% a year and should continue to do well with "lots of people entering the middle-class income [bracket in China] who can now afford to fly," he says.

While the global recovery continues, neither economies nor markets will move in straight lines, says Joy at RiverSource. Investors are right to worry about growing government deficits and tight lending. But, he warns, "if you panic at the first sign of trouble every time we have a dip in the market, you'll never reach your long-term goals.".

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