Where Is the Market Headed?

With the market stumbling in May, investors are asking: Is this the end of the three-year-old bull market, or merely one of the market's periodic corrections -- declines on the order of 10% or so? My hunch is that it's the latter. But I think the retreat signals an important change in leadership from small-company stocks and other risky stocks to safer blue chips.

The market has plenty to fret about. Inflation is clearly accelerating -- consumer prices have climbed this year at an annualized rate of 5.1% through April. That is something the Federal Reserve cannot ignore and means that more short-term interest rate hikes are likely. The budget and trade deficits are mammoth. The twin deficits portend additional declines in the value of the dollar, something that will add to inflationary pressures as prices of imported goods rise.

I can't recall a world with so many disparate geopolitical dangers: North Korea, Latin America, the Middle East -- the list is daunting. And oil prices are a drag on the world economy.

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But don't get too gloomy. The economy is healthy -- not only in the U.S., but in most of the developed world, and, yes, in most emerging markets. Long- and short-term interest rates are still comfortably low, and contrary to what the bears say, U.S. stocks are relatively cheap. The SP 500 is trading at less than 15 times estimates for this year's earnings.

Companies are awash in cash. In aggregate, they have become smarter at allocating capital, and they are paying more attention than usual these days to the concerns of shareholders. Profit margins are at historic highs, and wages seem unlikely to rise much. Productivity, defying the experts, continues to increase rapidly.

Before the recent sell-off, some markets had simply gotten way ahead of themselves. Ed Yardeni, chief investment strategist for Oak Associates said before the decline that he couldn'trecall another time when so many different markets were going virtually straight up: emerging markets, precious metals, industrial materials, oil and gas.

Most of the things that were headed straight up rediscovered gravity in May. Riskier stocks -- not only those from emerging markets, but stocks of small companies (both foreign and domestic), commodity and industrial materials producers, precious metals and homebuilders -- have tumbled. In short, almost everything that had done exceedingly well for the six years, beginning with the tech crash in March 2000, made an abrupt U-turn.

The decline in the broad market masks the extent of the carnage to riskier assets. The SP 500 fell 4% in May through Tuesday, before the market started back up. The tech-heavy Nasdaq dropped 7% in this same period. But the damange to emerging markets stocks, energy stocks and other industrial materials and precious metals was much worse. For instance, the MSCI Emerging Markets Index plunged 16% from May 9 through May 24.

Large-company stocks wake up

Taking over the market leadership, at least for now, have been stocks of large companies -- companies that have seen their profits and sales rise solidly in recent years, but whose stock prices have languished.

I think these blue chips are finally awakening from their slumber. Some began to rise in May; others fell much less than the market as a whole. When the blue chips finally do gain traction, they could well beat shares of smaller companies for years to come. After their six-year run, the price-earnings ratios of small companies are at historic highs relative to those of large companies. That can't last.

How to ride the blue chips

Where should you put your money now? For fund investors, a low-cost SP 500 index fund is the no-brainer choice. Because stocks of the largest companies dominate the index, it has uncharacteristically lagged most actively managed funds for years now. Three superb choices: Fidelity Spartan 500 Index (FSMKX) charges just 0.10% annually; Vanguard 500 Index (VFINX) costs 0.18% annually; and iShares SP 500 Index (IVV), an exchange-traded fund, charges just 0.09% annually.

Plenty of actively managed funds do a great job of picking large-company stocks, too. Some of my favorites are Marsico Growth (MGRIX), Oakmark (OAKMX), Oakmark Select (OAKLX), Selected American Shares (SLASX) and T. Rowe Price Growth Stock (PRGFX).

Stock investors should consider the likes of Amgen (AMGN), Cisco (CSCO) GE (GE), Johnson Johnson (JNJ) and Microsoft (MSFT).

Keep this in mind, too: If stocks do enter a bear market -- generally defined as a decline of 20% or more -- these blue chip funds and stocks are likely to hold up far better than riskier fare.

The big danger for investors is continuing to pile into what has worked lately. It's time to lighten up on risky stocks here and abroad.