Investors nervous as stock market eyes correction

Just six weeks ago, the stock market hit its highest point in three years. Then came mounting evidence that the economic recovery may have stalled.

The Standard & Poor's 500 index has dropped 6.8 percent since April 29. Declining just as quickly: the hopes of many investors and economists for robust growth in the second half of the year. Industries likely to do well if growth is strong, such as financial, technology, and industrial are already down 8 percent or more.

If the stock market drops 10 percent, it would signal a correction. Some market analysts, such as Citigroup's Tobias Levkovich, believe that the stock market is on that path now.

Corrections are common during bull markets, but one now could lead to more than the usual hand-wringing. That's because the Federal Reserve will end at the end of this month its program of buying Treasury bonds to support the economy by keeping interest rates low, which also makes stocks look attractive. The economy — and by extension, the stock market — will now need to show that it can expand without the Fed's help. What's more, the European financial crisis still isn't settled. Discussions about a second financial rescue package for Greece are two weeks away.

"No one rings a bell to let everyone know that we've hit a top or bottom (to the market)," says Nicolas Colas, the chief market strategist at ConvergEx Group, a technology and brokerage company in New York. And "no one knows how far this slide is going to go on for."

A drop of more than 20 percent would put an end to the bull market that started in March of 2009. The difference between a correction and a bear market, of course, is that a correction often presents a buying opportunity, and a bear brings prolonged pain. Corrections are fairly common during bull markets. There have been 18 of them in 12 bull market stretches since 1946, according to Standard & Poor's. They typically last four months and erase 14 percent of the stock market's value.

The reasons for a potential correction now are numerous. Thanks in part to high gasoline prices, the economy in the U.S. isn't growing as quickly as expected at the start of the year. Since the market's peak on April 29, more than 15 economic indicators, ranging from the number of new jobs added in May to how much consumers are spending at retailers, have been weaker than analysts had predicted. What's more, a scarcity of parts from Japan, which is in the midst of a recession after its tsunami and nuclear disaster, has also hurt U.S. companies and the global economy.

Some industries that prosper the most when the economy is growing are already close to a correction. Financial stocks in the S&P 500 have lost 9.7 percent since April 29. Energy, materials, and industrial companies aren't far behind: Each group has lost about 8.5 percent. Those four industries represent about 42 percent of the value in the S&P index. If they continue to fall, they could lead the rest of the market lower, Colas says.

That might not be all bad news. Buying during a correction can be profitable. The stock market's last correction started on April 23 of last year. By July 2, the S&P 500 had fallen 16 percent. Someone who bought then finished the year with a 24 percent gain, including dividends (without dividends, the gain was 23 percent.) That was nearly double the S&P 500's total gain for the year of 15 percent, including dividends, or 12.8 percent without. Of course, knowing when to buy during a correction isn't easy.

The fact that companies are still quite profitable is one reason analysts say they are guardedly optimistic that the market's recent losses will end. Many companies responded to the 2008 financial crisis by severely cutting staff, hoarding cash and restructuring their businesses to send profit margins higher. That has led to record profit margins for many companies.

So even if the economy is growing at only a 2 percent annual rate this quarter, as many economists now expect, corporate earnings should still be attractive enough to lift stocks broadly by the end of the year, says Paul Zemsky, the chief market strategist at ING Investment Management. Although the S&P 500 index is just below its historical price-earnings ratio of 15, he argues that stocks remain cheap compared with other assets like government bonds. The yield on the benchmark 10-year Treasury, for instance, is less than 3 percent.

"After months of being overly optimistic, people have become way too pessimistic about the future of the economy," he says. He believes that the S&P 500 will finish the year at around 1,400, which would be a 10 percent gain from its close Friday at 1,271. Forecasts from Bank of America and JP Morgan indicate support for that idea. The banks downgraded estimates for growth in the second quarter to about 2 percent, but expect stronger growth rates, of 2.9 percent or 3 percent, for the third and fourth quarters.

Others aren't so sure. Keith Goddard manages $250 million for Capital Advisors, an investment firm in Tulsa, Okla. He's worried because analysts have downgraded earnings estimates for some of his firm's top holdings, such as Qualcomm. And he thinks that there is at least a 1-in-5 chance that Greece will default on its bonds, which could lead to another financial crisis.

As a result, he's increased his cash holdings to 12 percent of his assets from 4 percent over the past six months. Defensive stocks like PepsiCo and Johnson & Johnson now make up nearly half of his portfolio.

If problems in Europe create a panic in the banking system, he says, "then you don't buy again until the market is down 25 percent."