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Is a correction coming?

A 10% pullback isn't uncommon in a bull market. Here's how to protect yourself.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 05/08/2013
  • Investing Strategies
  • Market Analysis
  • Exchange-Traded Funds
  • Mutual Funds
  • Stocks
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Let's hear three cheers for the market: The S&P 500 (.SPX) hit a record high last week, closing above 1,600 for the first time, and has jumped 160% since the lows of March 2009, including reinvested dividends.

Yet as the bull market rolls into its fifth year, many investors are no doubt wondering if the rally can last much longer — or if a pullback is around the corner.

As the bears point out, earnings growth for S&P 500 companies has fallen sharply since 2010. Analysts expect earnings to grow just 5.4% on flat revenues this quarter, according to Thomson Reuters. Wall Street expects earnings growth to pick up later in the year; revenues, not so much.

Globally, China's economy is slowing and the European economy is expected to shrink 0.1% this year, according to the European Commission. Economic reports are missing analysts' forecasts in every major global region, according to the latest Citigroup Economic Surprise Index-G10.

The U.S. may be the sturdiest house on the block, with economic growth around 2.5%. Yet while the economy is adding jobs, that's not translating to income growth, according to economist David Rosenberg of investment firm Gluskin Sheff in Toronto, who described the latest jobs figures as a "Potemkin payroll report."

"It is income, not jobs, that feeds into spending and it is that spending that feeds into GDP," he wrote in a note to clients, referring to gross domestic product, the broadest measure of a nation's economy.

Buying opportunity?

While the economy isn't surging, it's not sputtering into a recession. Inflation is tame, interest rates are low and stocks don't look expensive, says Dirk Hofschire, senior vice president of asset allocation research with Fidelity Investments. In fact, the S&P 500's price-to-earnings ratio has drifted lower over the past 13 years and now looks around average, historically, at about 15 times expected earnings.

That doesn't mean the market can't correct, dropping 10% or more. Since 1950, there have been 24 corrections, including three since 2010, Hofschire notes. And corrections aren't uncommon at this stage in the business cycle: the midpoint when corporate profits and economic growth are slowing.

"Markets can correct for many different reasons and a 10% fluctuation isn't anomalous," he says.

Yet corrections at this stage typically don't devolve into bear markets unless the economy unexpectedly slides into recession. Company profits are still growing. And the past few market pullbacks have been great times to buy stocks: The S&P 500 has climbed after every correction since 2010, including a 24% gain since the last correction, which ended on June 1, 2012.

Still, if you're concerned about a pullback or want some protection, here are a few moves to consider.

Dial back, get defensive

The most obvious step is to reduce your stock exposure. That may make sense if your stock holdings now exceed your long-term target allocation by at least 5%, says Alan Dossett, a financial adviser with Waypoint Financial Planning near Boston.

If you're holding stocks for the next five to 10 years, though, a correction is just a bump in the road. Pulling back now is tricky since you have to know when to get back in. Plus selling and locking in gains can be costly: You'll rack up short-term capital gains taxes if you've held a fund or stock less than a year in a taxable account.

Alternately, you may need to adjust your mix. Since U.S. stocks have rallied more than most foreign markets over the last year, Dossett suggests trimming your U.S. exposure and adding some foreign stocks.

One option: The iShares Core MSCI Total International Stock ETF (IXUS). The ETF holds just 3% in U.S. stocks, yields 3% and has an annual expense ratio of 0.16%.

Traditionally defensive sectors may be a good bet too, says John Kozey, an analyst and market technician with Thomson Reuters. Health care, utilities, consumer staples and telecom companies should hold up better in a downturn, he points out, even though they've uncharacteristically led the market in this rally. These sectors have above-average dividend yields and tend to fare better in the latter stages of an economic cycle, when growth is slowing.

"If you can be patient, you can collect a dividend above the S&P 500 and get paid to wait," he says.

ETFs to consider include the Consumer Staples Select Sector SPDR Fund (XLP), the Health Care Select Sector SPDR Fund (XLV), Utilities Select Sector SPDR Fund (XLU) and SPDR S&P Telecom ETF (XTL). These ETFs yield between 1.7% and 3.5% and expense ratios are below 0.40%.

The downside: Despite being defensive, these ETFs will lose money in a downturn. Some analysts say there are better opportunities in sectors such as energy and technology, which haven't rallied as much and look cheaper.

Companies that proved their mettle during the last bear market may also fare better if there's another downturn, says Kozey. Companies with strong balance sheets, healthy profits and low prices relative to the amount of cash they generate would fit the bill, he says.

One prime example: medical technology provider Becton Dickinson (BDX). The stock looks cheap based on its price-to-trailing-cash-flow, says Kozey. It's also more profitable than a year ago with higher returns on equity.

Other stocks with similar financial strength include packaging supplier Bemis (BMS), drugstore chain and pharmacy-benefits manager CVS Caremark (CVS) and Fidelity National Information Services (FIS), a financial services technology company, says Kozey.

These stocks pay dividends ranging from 1.6% to 2.7% and they're less volatile than the S&P 500, according to Morningstar.

The downside: Buying individual stocks can be riskier than investing in a diversified fund. You should research each company carefully to see how it fits within your broader portfolio and consult an adviser if needed.

Buy some protection

When fear reigns on Wall Street, investors flee to cash and high-quality government and corporate bonds. "If you need money in two to three years, you want capital preservation," says Dossett, the Boston-area adviser who uses the Fidelity Short-Term Bond Fund (FSHBX) and Vanguard Short Term Corporate Bond ETF (VCSH) for clients.

The downside: The funds yield just 0.4% and 1.2% and could lose money if interest rates jump. Bond prices and yields move in opposite directions.

Gold is another option as a kind of insurance policy against a crash. The SPDR Gold fund (GLD), which holds physical gold in a London vault, climbed 7.6% in 2008 while the S&P 500 plunged 37%. Gold has downsides too, though. For more on the pros and cons see "Is it a good time to buy gold?"

You also can buy some protection with a long/short mutual fund. These funds hedge their bets on stocks: They invest in some stocks they think will rise in price and they "short" other stocks, betting their prices will decline. These funds may be less volatile than the broader market and they tend to lose less when stocks decline, according to data from Morningstar.

One top-ranked fund in the category: Wasatch Long/Short Investor (FMLSX). The fund is about two thirds as volatile as the S&P 500, according to Wasatch, and typically falls around half as much as the market in downturns.

Morningstar analyst Mallory Horejs describes it as "one of the more appealing" funds in the category. Indeed, the fund lost 21% in 2008, much less than the broader market. Over the past five years, the fund returned 6.1% compared to 5% for the S&P 500, beating 92% of long/short funds, according to Morningstar.

The downside: The fund's 1.51% expense ratio is higher than most traditional stock funds. The fund won't keep up with a rising stock market and has slightly trailed the S&P 500 since the fund's launch in 2003.


Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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