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Is The Market Correction Finally Here?

For the past two months, the stock market has been a lot like an ace rock climber able to keep climbing higher no matter the obstacle. Stocks shrugged off turmoil in the Middle East that has triggered a sharp spike in oil prices, the earthquake in Japan, the continued sovereign debt woes coursing through Europe, brewing concerns over the timing of a shift in Federal Reserve policy, and just kept climbing the proverbial wall of worry.

Until now.

Over the past five trading days through April 12, the Standard & Poor's 500 stock index has lost 1.74 percent and the Nasdaq is down 2.2 percent. Perhaps this is just the briefest of pauses, but it could also finally be the start of a bigger pullback. If so, it sure shouldn't come as a surprise.

Some points to consider:

  • Stocks need to take a breather. Last summer, stocks were in the midst of an unsurprising pullback. After the epic rally from March 2009 through the spring of 2010 had pushed the S&P 500 up more than 60 percent, the benchmark index was off about 10 percent when Ben Bernanke stepped in. His announcement in late August of the Fed's intention to go ahead with another round of quantitative easing sparked a 30 percent rally to where we're at now. But with that push from the rear by the Fed looking more and more like it's about to end -- and the prospect of tightening growing -- the odds increase that another pullback is in the offing
  • The outlook is a little less positive. Back in December when President Obama agreed to a tax compromise that extended the Bush tax cuts through 2012, economists figured that would give a nice boost to 2011 GDP growth, with some raising their estimates to close to 4 percent. But with all the brewing headwinds, economists polled by the Wall Street Journal are now saying first quarter growth will come in at 2.6 percent, not the 3.6 percent they expected two months ago.

Continued sluggish job growth that is barely making a dent in unemployment, concerns that inflation may be more of a factor than earlier anticipated, and a 30 percent spike in oil prices since the uprising in Egypt launched turmoil throughout the Middle East has a funny way of making people less optimistic. Add in slumping confidence among small business owners and consumers, and that's quite a wall of worry to scale.

And in the past day, oil and gold have backed off their highs, signaling that the fierce commodity rally may be a bit overdone. In fact, there's suddenly a new round of oil chatter that we in fact have plenty of supply to support lower prices, suggesting it's speculation and not market fundamentals that have driven oil to its recent highs.

  • It's harder to keep the rosy glasses on. Add that all up and there's no easy case for why stocks should keep climbing. And keep an eye out on how first quarter earnings play out in the coming weeks; the early announcements haven't sparked market confidence. Besides, while the optimists in the crowd love to focus on the fact that the S&P's 12 month price/earnings multiple is just 15, the respected Shiller price/earnings ratio, which looks at a 10-year inflation-adjusted market multiple, is currently 40 percent higher than its historic norm. Translation: the market is anything but cheap.
  • The pause that refreshes? Sam Stovall, the chief investment strategist at Standard & Poor's, recently took a look at what the market tends to do after it has recovered from a correction, for insights on what may be in store now. As the table below shows, the most common occurrence is a pullback, which S&P defines as a decline of 5 to 10 percent -- this is how things have played out 12 times since 1945. Corrections of 10 to 20 percent have occurred just three times, and only twice has a rally after a correction ended with a thudding bear market loss of more than 20 percent.

That, of course, is not a guarantee that we will get a gentle pullback of less than 10 percent (or for that matter, that events of the past few trading days are in fact a harbinger of more to come). But for what it's worth, the same economists who recently reduced their Q1 GDP estimates are also expecting growth to pick up to a 3.6 percent rate in the 4th quarter. In addition, the third year in the presidential election cycle typically is kind to stocks.

So what to make of all this? Well, perhaps the healthiest move for your portfolio is to remember your stock holdings are for the long haul. Getting too cute by trying to bail out ahead of a pullback or correction just leaves you exposed to missing the next leg up.

Photo Courtesy Flickr user alexindigo

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