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Healthy market correction? Here's how to play it

Tuesday, 14 Jan 2014 | 6:12 AM ET
Correction coming to 'clean up the froth': Pro
Tuesday, 14 Jan 2014 | 2:00 AM ET
Bill Smead, CEO and CIO of Smead Capital Management, says we are at the beginning a stock market correction that will "clean up the froth".

A rout in global markets this week has led analysts to believe a short-term market correction is upon us. But rather than cutting their losses, some have told CNBC how they plan to make money, adding that such a correction can be "healthy".

"It's going to be a correction to clean up the froth. And that's what really needs to happen," Bill Smead, chief executive and chief investment officer at Seattle-based investment advisor Smead Capital Management told CNBC Tuesday.

Paul Kavanagh, partner and senior market strategist at investment advisor Killik & Co, believes that investors can tell more about the market when it's in a correction.

"When you get a down market, I tend to enjoy these days. The reason being I think you can tell a little bit more about the market when it's tested," he told CNBC.

(Read More: US stocks starting off 2014 in correction mode?)

Housing is a sector that both analysts said they have been looking at. In the U.K., government stimulus measures that hope to boost the number of new homes being built have coincided with a 5.5 percent year-on-year rise in prices. Kavanagh believes that this market will see volume growth in the next four or five years and urged investors to buy stocks on this dip.

Smead, meanwhile, felt the same on the state of U.S. housing which has shown flickering signs of recovery in 2013. Housing starts in the U.S. surged to a six-year high in December. Smead, believing that the U.S. is on the verge of a renewed increase in demand for new homes and added a builder to his investment portfolio in December.

Traders work on the floor of the New York Stock Exchange.
Jin Lee | Bloomberg | Getty Images
Traders work on the floor of the New York Stock Exchange.

Both Smead and Kavanagh agreed that a market dip would mean a return to traditional stock-picking with investors once again looking closely at fundamentals for companies and not riding on a wave of enthusiasm at the market rally.

"The froth is frustrating to someone that really wants to own businesses.," Smead said. He noted that a correction in the early 1980s had followed a period where small capitalized stocks had outperformed larger capitalized stocks - particularly in the tech sector.

(Read More: 'Lofty' market ripe for at least 10% drop: Goldman Sachs)

He added that he believes this could now be playing out once more with initial public offerings (IPOs) in the sector managing to raise surprisingly large values.

These overvalued tech stocks could then infiltrate larger indexes as their success grows, he added.

"The S&P 500 now is susceptible to being corrected by froth that used to only hit the small cap indices," he said.

'Orgy of acquisitions'

U.S. stocks fell sharply on Monday, with the Dow Jones Industrial Average slammed with a triple-digit drop, as investors braced for the latest round of quarterly earnings.

Goldman Sachs analysis this week said that a stock market correction is approaching the level of near certainty, citing a major paradigm shift for Wall Street in how to achieve price gains. The firm's strategists called the S&P 500 valuation "lofty by almost any measure" and attached a 67 percent probability to the chance that the market would fall by 10 percent or more, which is the technical yardstick for a correction.

(Read more: Bob Doll: 10% stock correction coming, gold going down)

Correction will be 'healthy' for market: Pro
Paul Kavanagh, partner and senior market strategist at Killik and Co, says the atmosphere of low volatility in the market has made investors complacent and a correction will be "healthy".

Jonathan Tepper, a partner at macroeconomic research firm Variant Perception told CNBC that there are several indicators that show equity markets are looking dangerously euphoric, but said he couldn't predict whether indexes would continue the fall seen on Monday.

"Stocks are very stretched relative to bonds. Also if you're looking at valuations they're not cheap, particularly in the U.S. and developed markets," he said.

Tepper was particularly wary of media and technology stocks, indicating that a strong rally in 2013 - fueled by firms buying back their own equities - was reason to be believe that they were overvalued.

"The thing we haven't seen yet is a M&A (merger and acquisition) wave...we're starting to see some" he said.

"What tends to happen in most market tops is that you get an orgy of acquisitions and destruction of capital."

By CNBC.com's Matt Clinch. Follow him on Twitter @mattclinch81

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