After A Roller-Coaster Month, Is A Bear Market On Its Way?

If the market was looking to get our attention, it has it now.

Since Jan. 13, the SP has dropped at least 1% on three occasions. It now stands nearly 5% below its 52-week high.

At this point, investors have begun to wonder if the market choppiness is a sign of a looming correction, which is defined as a 10% pullback (a bear market is a pullback of 20% or more).

It's been quite a while since we've had a market correction: It happened once in 2010, 2011 and in the middle of 2012, but it hasn't happened since.

Notably, each correction has been followed by an impressive rebound, and some investors would welcome such a purge. In a market where values remain hard to find, pullbacks create solid openings. If we are entering into a corrective phase, history suggests it would last a couple of months. (The 2011 correction was quite rapid and due solely to the government shutdown.)

Frankly, it's unclear if the market's recent gyrations will trigger a major directional shift. The economy appears fairly healthy, earnings season has been reasonably impressive, and Washington gridlock doesn't seem to be an issue at the moment (though another debt ceiling fight may be in the works).

So if the backdrop for stocks is fairly benign, why has the market sustained a series of scary drops in recent days? Perhaps it's simply a desire to lock in profits early in 2014 after great gains in prior years. Perhaps it's a concern that the Federal Reserve's slow withdrawal from its quantitative easing (QE) program. Some suggest that it's due to the troubled economies in emerging markets. More than likely, it's a combination of all three.

But it's simply hard to compare the current macro backdrop to the tougher times the market faced during past pullbacks. Sure, the Fed's retrenchment removes a positive catalyst from the market, but it's also a good sign that the economy is now healthy enough to flourish without that stimulus. The economy grew more than 3% in the fourth quarter, thanks to spending by both businesses and consumers.

And though stocks may have been ripe for profit-taking after a strong rally in 2013, they aren't necessarily expensive either. Most price-to-earnings (P/E) measures of the market are at the midpoint of historical ranges.

The scary noises coming out of emerging markets are a bit more unsettling. As we saw in 1998 when the Thai baht and Russian ruble collapsed, even developed markets can take a swift (if temporary) hit.

And China, which tends to lead sentiment in emerging markets, appears headed for a slowdown. But the Chinese government has shown a repeated willingness to stimulate the economy whenever signs of weakness emerge. Any stimulus moves would help plunging emerging markets to find a floor.

How To Invest During A Sideways Market
It's too soon to know if the recent market action will lead to a full-blown correction. A herd mentality could set in, and investors could rush to sell, simply because they fear that their peers will do so as well. Indeed a fresh survey of investor sentiment showed more bears than bulls for the first time in nearly six years.

If you see the percentage of bulls drop to just 25% in the American Association of Individual Investors' weekly survey, that will be a clear sign that it's time to buy stocks.

Investors Are Feeling Less Bullish Lately

Source: American Association of Individual Investors

Even as the market posts some scary dips in recent weeks, investors have become conditioned to use the pullbacks as buying opportunities. A "buy on the dips" strategy can prove quite fruitful, but as we saw this past week, a post-plunge rally on Thursday was followed by a fresh sell-off on Friday. If dip buyers get repeatedly get burned, they'll stop doing so. And that's when the market pullback could build steam.

Still, for investors who have the resources to track a wide variety of stocks they consider to be appealing, the market gyrations provide clear openings.

As the SP 500 was falling 5% from Jan. 22 through Jan. 29, a number of small and mid-cap stocks fell at twice or even three times that rate. In a market that has provided few entry points in the past few years, these pullbacks will be increasingly embraced as the indices fall farther from the 52-week high. The economy is simply too healthy to justify any major sustained market pullback.

Of course most small cap stocks have yet to deliver fourth-quarter results and issue 2014 guidance, so there's risk in pursuing any stocks that have yet to report. Instead, this is a great time to focus on stocks that have pulled back from recent highs and set up a calendar of their reporting dates. A solid outlook, paired with a still-constrained stock price, could lead to a chance for quick profits, before the market truly stabilizes and returns to these sold-off names.

So what's the short-term plan? Watch and wait. It's a good time to nibble at bargains, but there's no need to rush. If markets don't stabilize, then a steady grind lower could trigger forced selling as the levels of margin debt remain at alarming levels. As this recent Seeking Alpha article noted, margin debt rose nearly $70 billion in the last six months of 2013, to a record $444 billion.

Risks to Consider: Market psychology is an intangible variable. Investors have repeatedly seen the glass as half-full in recent years as companies and the economy give mixed signals. If investors decide to start seeing the glass as half-empty, then there is no need to "fight the tape."

Action to Take -- In the context of quarterly reports thus far, most companies have cited a fairly solid backdrop for business. Economic indicators suggest we may see 3% GDP growth in 2014, and many companies, especially those with minimal foreign sales exposure, are poised to benefit from the brightening economic picture. Those are the stocks you should be focusing upon as the market starts to uncover fresh value plays.

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