4 Reasons Why You Need to Prepare for a Possible Stock Market Correction


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If you're being kept awake by a neighbor's party, you may as well get dressed and join the fun. That was the possible reaction to Wall Street strategists, who issued fairly dour "year-ahead" reports back in December, predicting the market would soon stall out. In hindsight, they were flat wrong, with the S&P 500 now handily above even the most bullish price targets.

Well, analysts at Credit Suisse threw in the towel in mid-March, boosting their target for the S&P 500 to 1,470. That's about 4% above current levels. The key change in their thinking: "We still expect [U.S.] GDP growth to slow ... but the risk now is that it slows less than we expected." And they think that stocks remain fairly inexpensive, even after the recent surge, adding that stock gains are likely to come at the expense of bonds , which are likely to lose value as bond yields rise.

Analysts at Goldman Sachs had been quite bearish until recently. Back in February, I noted that they thought the S&P 500 was likely to slump back to 1,250 in the face of tepid global growth in the United States and a recession in Europe. They also suggested the index would plunge to 900 if the European mess led to a global recession in coming quarters.

Now they are singing a very different tune. In a much-discussed report issued on March 21, Goldman's analysts are suggesting we're entering an era of the "long, good buy" for stocks (and as Credit Suisse suggests, a commensurate move out of bonds). [Our own Adam Fischbaum recently suggested that readers begin to rotate out of bonds right now before the herd catches on.]

Goldman's core belief is that the risk premium associated with stocks is now quickly diminishing. They constantly analyze reams of historical data related to perceived risk and projected returns, recently concluding that the current investor mood may still be too cautious. "While risks abound, and future earnings may be weaker than experienced over the past decade, there are growing reasons to believe they may not be as bad as markets are pricing." In fact, they see a fairly bright global economic picture in the years ahead as continued strong growth in key emerging markets boosts trade across nations: "Our global projections show that the next decade is likely to be a peak period for global growth."

Even as investors focus on the long-term positive backdrop for stocks, they can't ignore the fact that stocks have already made a strong run in both the recent short-term (the past six months) and the medium-term (the past three years). That's why investors need to pay sharp attention to results and commentary in this upcoming earnings season . If ill winds start to blow, then it's time to raise cash and position yourself for long-term opportunities AFTER they have seen some profit-taking.

Here's what I am watching this earnings season...

1. Europe's impact on earnings
Back in late January, a wide range of blue chip companies noted that operations in Europe were becoming challenging, but not necessarily slumping deeply. That partially explains the post-earnings trading gains we've seen, as Europe-related fears receded. Yet it's too soon to signal that we're in the clear. Listen to companies like Ford (NYSE: NYSE: F), GE ( GE ) , and Procter & Gamble ( PG ) to be sure whether they are still saying Europe is simply weak but not miserable.

2. Margin compression
Investors may not yet fully grasp that profit margins have likely peaked and could even turn down a bit as input costs such as labor and material start to rise. I discussed this topic roughly a week ago and noted that "year-over-year profit margins are expected to fall slightly in the first three quarters of 2012 and rise only modestly in the fourth quarter. The clear takeaway: to boost profits, companies are increasingly relying on good old-fashioned sales growth." If margins hold firm or actually rise a bit for many S&P 500 firms, then this rally can surely continue.

3. Will Washington spook the stock market?
In the few years following the economic slump of 2008, many executives spoke of an inability to commit to major internal investments while the legislative gridlock in Washington created so much uncertainty. Now, we're just a few quarters away from the next budget battles, primarily focusing on the expiration of Bush-era tax cuts and potentially deeper reductions in government spending. In a nutshell, if corporate executives believe that these issues will be addressed in a mature fashion and Washington can avoid gridlock, then you can expect to hear about robust plans for investments in growth at many businesses. Yet if executives remain cautious about fresh spending commitments, then they may unwittingly sow the seeds of an economic slowdown and a slumping stock market.

4. The economy still matters
As the upcoming earnings season hits a crescendo, so will a wave of economic data. The economic backdrop has looked very enticing lately, but a chorus of economists continues to warn that we'll see a pullback in the data this spring, as was the case in 2011.

Key items to watch include:
-- April 3: FOMC Minutes are released that give a read into the Federal Reserve's next move
-- April 6: Monthly employment report
-- April 13: Consumer Price Index
-- April 24: The Conference Board's survey of consumer confidence
-- May 1: The ISM manufacturing index
Risks to Consider: The market's recent move tacitly implies an improving outlook for corporate profits in coming years, though proof of that trend isn't yet in evidence.

Action to take --> There is no contradiction between having a bullish long-term view and a cautious near-term view, and I think that's probably the best philosophy to have right now. Note that even as the market rallied sharply from the March 2009 lows, there were several major dips in between, and knowing when to raise cash and then putting it back to work later has become a key trait for many skilled investors.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing
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