Headed for a Fall?

If the stock market crash of 2000 taught investors anything, it's that eventually all good things must come to an end. The problem is, almost every type of asset class--from real estate to crude oil to gold to hedge funds to stocks--has been good to investors lately. The Dow Jones industrial average, in fact, recently touched a new six-year high and is within reach of an all-time record. So if another investment bubble is likely to burst, where will the first pop occur?

While all eyes have been fixed on the housing market, a growing number of market watchers are now convinced that the stock market is in for a major correction this year. Jeffrey Hirsch, editor of the Stock Trader's Almanac, thinks the Dow will peak at around 11,500 but could then plummet to around 8,500. This would represent a 26 percent plunge in equity values. "It could be a little more, depending on how ugly things get," says Hirsch.

Liz Ann Sonders, chief investment strategist at Charles Schwab, is not predicting a full-blown bear market (a drop in the major indexes of 20 percent or more). But, she says, "we may be in store for a midyear pullback that's a little more severe than we've experienced in the last several years." At the very least, says Jeffrey Kleintop, chief investment strategist for PNC Wealth Management, the market could give back the gains it has achieved so far in 2006. Blue-chip stocks are up about 5 percent, while shares of small companies are up around 14 percent.

Many investors don't seem to appreciate just how well the stock market has performed since the last bear market ended in October 2002. Equities have actually outperformed residential real estate since late 2002, advancing nearly 20 percent annually.

How much longer can this party last? James Stack, president of InvesTech Research, notes that bull markets are usually peppered with minor corrections and pullbacks. These short-term losses are important for the longevity of bull markets, as they tend to drive away investors who lack conviction and strengthen the resolve of the remaining shareholders.

But since the first quarter of 2003, stocks have not experienced a single pullback of 10 percent or more. "That's a long time, especially for an aging bull market like this," says Robert Doll, president of Merrill Lynch Investment Managers. In fact, this is now the fourth-longest uninterrupted bull market in history, according to InvesTech.

As a result, many think stocks are long overdue for a sell-off, especially with the markets about to enter the summer of a midterm election year. The stock market, too, has its seasons. Sam Stovall, chief investment strategist for Standard & Poor's, recently studied the market's performance in various years of a presidential cycle. The second year of a presidential term--the midterm election year--is historically the worst time for stocks. Since 1945, the S&P 500 has gained only 4.3 percent in such second years, versus 18 percent in third years of presidential terms. What's more, the second and third quarters of second years are the worst times to be in the market. Historically, stocks have lost 2 percent in the second quarter of midterm years and 2.2 percent in the third. "I'm thinking that the old Wall Street saying 'Sell in May and go away' might make some sense this year," says PNC's Kleintop.

History agrees. The equity market tends to hibernate between May and October. Meanwhile, the November-through-April period is typically the best for stocks. According to S&P, the average gain for blue-chip stocks between November and April is 7.1 percent. Compare that with the meager 1.5 percent returns between May and October.

It's not just seasonality that worries investors. A host of other reasons can make investors wary of the state of the markets. Among them:

Rising oil prices. Though oil at $70 a barrel and more hasn't spooked the stock market yet, "if left unchecked, oil creep will force a correction," says Jack Ablin, chief investment officer for Harris Private Bank. Not only do high oil prices eventually crimp profit growth; they also raise the specter of inflation.

Rising interest rates. Since January, the yield on the 10-year treasury note has climbed from 4.33 percent to as high as 5.11 percent. Rising rates threaten to slow the economy while they make bonds a more attractive investment alternative to stocks. Of course, bond yields are still relatively low by historical standards and may need to move above 6 percent to scare the equity markets.

A new Federal Reserve chairman. The last time someone new took over atop the Fed (Alan Greenspan in 1987), stocks lost 22 percent in the first six months of his term. While few question the economic acumen of new Fed Chairman Ben Bernanke, uncertainty abounds concerning how he will guide the nation's monetary policy. Bernanke inherited the Fed as it was still raising short-term interest rates to slow the economy and control inflation. History shows that the Fed has a knack for raising rates too much, often sending the economy into recession. Even if Bernanke stops lifting rates after the Fed's meeting in May, there's this to worry about: According to Ned Davis Research, the Dow has lost nearly 5 percent, on average, six months after the last in a series of Fed rate hikes.

Geopolitical saber rattling. Iran's nuclear ambitions have pushed Iraq's troubles off the front pages. Continued talk of military strikes against Iran could send stock investors fleeing to cash, as the price of crude might approach $100 a barrel.

An emerging-markets bubble. More new money flowed into emerging-markets stock funds in the first quarter of 2006 than in all of the preceding 10 years, according to Robert Adler, president of AMG Data Services. The frenzy to chase the eye-popping returns of emerging-markets stocks has some market watchers worried. A slowdown in Asia or Latin America could spur an immediate sell-off in the foreign markets that could spill over into U.S. stocks.

A cooling housing market. A slowdown in housing could drive some investment dollars out of real estate and back into stocks. But, more important, stagnant or falling home prices might jeopardize consumer spending, slowing the economy. And a sluggish economy is no friend of the stock market.

The slowdown in earnings growth. The surprising strength of profit growth has kept the equity markets humming in recent months. Earnings of companies in the S&P 500 are expected to grow around 13 percent in the first quarter, which would mark the 11th-straight quarter of double-digit gains, according to Thomson Financial. Yet this streak could end in the second quarter, especially if oil prices keep rising (a real possibility because of the situation in Iran, the start of the summer driving season, and the upcoming hurricane season in the oil-rich Gulf Coast). Indeed, S&P is forecasting that earnings will grow only around 7 percent in the second quarter. That could be enough to push stocks lower.

Yet in recent quarters, "corporate profits have been fairly resilient," says Chris Orndorff, head of equity investments for Payden & Rygel. And if profits continue to surprise on the upside, "it should give some positive support to the equity market," he says. Orndorff does not believe a bear market or even a correction is inevitable; he calls "a pause or sideways market" more likely.

Experts say the stock market perpetually climbs a wall of worry--so the laundry list of threats facing equities is nothing new. "People can argue that Iran is now a big threat, there's the question of the Fed overshooting, there's avian flu--it all makes sense," says Ernest Ankrim, chief investment strategist for the Russell Investment Group. But he notes that past crises have roiled the markets, such as the Asian currency crisis and the implosion of the Long-Term Capital Management hedge fund in the late 1990s. "It's not like we haven't had shocks to the system," Ankrim says. Somehow, stocks have managed to climb higher.

If there's a silver lining to all this talk of a pullback, it's that most investors--be they bears or bulls--foresee an end-of-the-year bounce for stocks. Fourth quarters of midterm election years have historically been the best period for equities. According to S&P, the average gain of blue-chip stocks in the final three months of midterm election years is 7.6 percent. "It's going to be a great buying opportunity," says Hirsch of the Stock Trader's Almanac.

So, the moral of this story: If you plan to sell in May and go away, don't forget to come back in time for Halloween.