Market Outlook: Selloff in Stocks May Not Be Finished Yet

Analysts say the next couple of weeks could be rough for the stock market as investors keep a close eye on interest rates.

"We're probably going to see some more selling," Sebastian Leburn, chief investment officer at Weiss Capital Management, told CNBC.com. "We could still see further weakness in the short-term. The recent runup in interest rates is putting a little fear into the market. Over the next couple of weeks, we could see more volatility with more profit-taking."

Stocks managed to rebound on Friday after three straight sessions of losses. The selloff was sparked by a sharp rise in interest rates, with the yield on the benchmark 10-year note exceeding 5% for the first time since last summer.

"We need some time to settle down and see if bond yields stabilize somewhat," said Steve Goldman, chief market strategist at Weeden & Company. "We would take more of a 'go slow' approach at this juncture and wait things out for another few weeks to see how much damage is likely to occur."

On Yield Watch

Next week, investors will get key inflation data from the Producer Price Index and the Consumer Price Index. Wall Street will also get the latest reading on retail sales and the University of Michigan's consumer sentiment reading. However, some analysts say the bond market will probably continue to hang over the stock market in the near-term.

"If the long bond heads toward five and a half percent, that's going to scare some people," said David Tice, portfolio manager of the Prudent Bear Fund.

"Overall the stock market will still do well, but our biggest fear that could derail this is if interest rates would still go up," said Leburn.

Some investors are concerned higher interest rates could stall the recent corporate buyout frenzy.

"Investors haven't been able to imagine how the leveraged buyout boom would end," Merrill Lynch Chief Investment Strategist Richard Bernstein wrote in a research report this week. "Rising rates and rising equity valuations could do the trick."

However, Keith Wirtz, chief investment officer at Fifth Third Asset Management, does not believe rates are high enough to have a negative impact.

"There's a psychological moment about the 5% level, but if you think about rates at 5% to 5 and 1/2%, that is still fairly low relative to historic standards," said Wirtz. "We don't think it impedes companies from continuing to do capital expenditures and do project work."

Bull Market Not Over Yet

Even though stock analysts will be watching bonds like a hawk in the coming days, most money managers still believe the market will finish the year higher. Bulls believe the same catalysts that have taken the Dow and the S&P 500 to record levels will continue to drive the market from near-term pullbacks.

"This is merely a correction within a spirited bull market," said Douglas Peta, market strategist with J. & W. Seligman. "I think that liquidity is such that there's plenty of support for stocks. M&A activity is essentially putting a floor under stocks along with all of the other impacts of global liquidity."

Others believe the next catalyst will come in a few weeks when second-quarter earnings announcements get underway. Analysts surveyed by Thomson Financial are now forecasting Q2 aggregate earnings growth for the S&P 500 at 4.0%, compared with 6.8% at the beginning of the year. Corporations beat lowered earnings estimates for the first-quarter.

"We got some positive earnings from the retailers this week and that was very important, showing that April was an aberration," said Kevin Divney, chief investment officer at Putnam Investments. "The next catalyst will be when the companies begin to trade more on the fundamentals and less on the macroeconomic outlook."

Be Well Allocated

Leburn of Weiss Capital Management says retail investors should not try to time the market, just make sure their portfolios are well allocated. Many analysts, including Leburn, are suggesting long-term investors who want to put new money to work in stocks look at high-quality, large-cap companies.

"One of our favorite areas is dividend-paying larger stocks," said Leburn. He recommends Johnson & Johnson. "This is a great company, with strong dividends, relatively low valuation, low debt levels and strong cash flow," he said.

Leburn also recommends Bank of America. "We think it's substantially lower than its true worth," he said. "If we can pick it up anywhere in the 50s, we want to do that."

Weiss Capital Management owns Johnson & Johnson and Bank of America in its investments.

Wirtz of Fifth Third Asset Management agrees that large-cap companies are the best buys right now. He recommends Diamond Offshore Drilling.

"We think it has great growth on the horizon," said Wirtz. "It's got the ability in terms of cash flow to provide special dividends. It looks really cheap. The price is eight times next year's earnings."

Wirtz also likes Accenture and Google in the technology space. "Accenture is what we describe as the creme de la creme in the IT management consulting area," he said.

"We like Google because they have what we think is a secular momentum against their competition," said Wirtz. "We think over the last three or four quarters, they've exceeded everyone's expectations on the EPS number. We think they are going to continue to do that."

Fifth Third Asset Management owns Diamond Offshore Drilling, Accenture and Google in client accounts.

Tice with the Prudent Bear Fund, is warning caution and encouraging investors to be more in cash and consider more short positions. If you're looking for stocks, he says precious metals are the way to go.

"We still like precious metal companies like uranium companies, as well as gold and silver," said Tice. "We believe that in this kind of environment, the dollar will eventually decline. We think there has been under-investment in the mining area over the last 20 years and we think gold will do well relative to the dollar."

Phyllis Burke Goffney is a news editor at CNBC.com. She can be reached at [e-mail].