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How to Play This Market: Sectors, Individual Stocks

As the stock market slogs through a dismal year, some investment pros think it's time to look beyond the relative safety of index funds and take a chance on specific sectors of the market or even individual stocks.

Though funds tracking the Dow Jones Industrial Average, the Standard & Poor's 500, the Nasdaqand the Russell 2000are usually the safest and most efficient way to play stocks over time, the market's negative returns so far this year have generated a different mindset.

Now, the term "stock-picker's market" is cropping up, meaning individual investors shouldn't rely solely on index funds but consider putting at least part of their portfolio into sector funds or well-run, solid companies that can offer above-market returns.

So far this year, index funds have given many investors a huge haircut.

The iShares Dow Jones Select Dividend Index Fund, which mimics the movement of the bluechip index, is off more than 18 percent this year, comparable to the index's overall loss. The iShares Russell 2000 Index Fund, which tracks the small-cap index, is off 5.5 percent, also near the overall loss of the group.

"I would describe the environment as a vicious sector rotation," says Todd Salamone, an analyst at Schaeffer's Investment Research. "There aren't rallies that are broad-based."

That has analysts looking for individual stocks likely to rally, even for a short time, in a bear-market atmosphere. But they advise caution for investors looking to employ the strategy.

"It's a wise play only for those looking for a higher-than-market return and willing to pay attention," says Jordan Kimmel, a hedge fund manager at Magnet Investing.

Redefining Risk

Many advisors still counsel clients to stay away from individual stocks because of their volatility. Instead, they urge taking advantage of hundreds of exchange-traded funds that track various sectors within and provide protection against violent swings in individual shares.

Even so, Kimmel says investors need to reconsider the traditional definitions of risk. Investors who pick stocks that are timed to capitalize in longer-term trends can withstand the ups and downs of normal stock movements.

"All the best investors out there, those that have had the greatest returns, have been willing to accept volatility and try to redefine what risk means," he says. "The instruments with the smallest volatility long-term have the smallest returns. The question is, are you willing to accept fluctuation in terms of getting to your ultimate goal? I think that's what people need to ask."

How to Invest During the Financial Crisis. See Video at Left.

Kimmel likes energy plays, on the notion that global demand is not going to go away not merely in fuel for transportation but also for fertilizer to grow crops and in exploration and other areas. In that space, his top-rated stock currently is McMoRan Exploration, a Louisiana-based company that controls more than 1.52 million acres of gas and oil leases in the Gulf of Mexico and Gulf Coast areas.

In addition, Kimmel recommends Agrium, a Canadian agribusiness company.

"I think that global buildout is bigger than anyone imagines," he says. "There are tremendous long-term trends to play there that don't go in and out on a daily basis."

Buying a Backup

Salamone also favors energy plays right now but believes investors should use ETFs to hedge their individual stock plays.

For instance, he considers James River Coal a smart play but backs it up with the Energy Select SPDR fund or the Market Vectors Coal ETF.

Jay Rushin, portfolio manager at AIG Sun AmericaRushin, wades even more cautiously into stocks. He specializes in small-caps but in the current environment cautiously advocates playing consumer staples that can withstand sustained downturns in the economy.

A few selections he looks at are Tyson Foods, a company getting a lot of attention as corn prices drop and global food demand increases, and Chiquita Brands International , which is coming off a strong second-quarter performance.

But Rushin is not optimistic about the overall environment for stocks.

"This is kind of how it always happens in this type of market. Everyone is super-skittish," he says. "At this point it seems awfully dismal and it's very hard to say whether we're going to start to emerge from this in six months or two years."

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