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An Orderly Selloff? Maybe So, But Investors Fear the Worst

Despite a market selloff that by nearly all accounts appears to be both orderly and expected, investors find themselves bracing for the worst.

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The Standard & Poor's 500 has lost nearly 8 percent from its most recent 2010 high, approaching the 10 percent drop associated with a formal correction. Except for a 3 percent plunge last Thursday the drops have been relatively incremental and on normal volume levels.

Yet strategists find themselves dealing with skittish clients who wonder whether the market could be setting up for another big fall.

"I think it's pretty normal, what's going on," says Nadav Baum, managing director of investments at BPU Investment Management in Pittsburgh. "You get a little crack in the armor, you get the correction that everyone's been talking about. What happens? You get more skittishness, you get more fear and the market sells off."

The rough start to 2010 comes even as earnings season has seen companies beating expectations by a 3-to-1 ratio with revenue and outlook both on the upside.

Yet the ghosts remain of 2008, when investors saw the stock market soar to historic heights the previous year only to crash beneath the weight of subprime defaults and the virtual collapse of the world's banking system.

This time around, the specters consist of sovereign debt weakness in countries like Greece and Spain and worries that the global financial markets are weakening even as economic signs improve.

US investors also are concerned about what will happen as the Fed pulls away its various liquidity measures and starts raising interest rates.

"We are in a deleveraging post-credit cycle bubble," says Matt Havens, partner with Global Vision Advisors in Hingham, Mass. "The handoff of government stimulus to the private sector won't be a transition that the economy is capable of right now. As people wake up to that, they will perceive a lot more risk in equities."

Investment advisors have shifted strategies in 2010 to combat a market that is trending in a decidedly different direction from its violent rally off the March 2009 lows.

Whereas last year's theme focused on companies that had taken the greatest beating from the 2008 market smackdown, the emphasis now is on quality.

Dividend-paying large-caps, which trailed the rally, are back in favor.

BPU's Baum, for instance, likes Coca-Cola , which has fallen more than 7 percent in 2010 and he now feels represents a bargain.

While that may not sound terribly sexy for investors looking for aggressive returns, it beats the alternative.

"We're telling people the same thing we were telling them last year—continuously move away from equities and be more defensive and move toward absolute-return strategies," Havens says. "The challenging part is this is a trader's market and not an investor's market."

High volatility among much of the market makes for a more challenging environment that tests the patience of long-term investors. Havens says his firm is using mutual funds and employing long-short strategies to cover periods when the market moves lower.

Investors also may want to rethink the amount of money they're allocating to foreign markets until the sovereign debt issues are settled. The costs to insure debt— or credit default swaps—of many foreign nations has increased significantly in recent weeks.

"You've got to be very careful. Anytime you've got this level of volatility it creates some huge opportunities, but you've just got to be careful with it," says David Twibell, president of wealth management for Colorado Capital Bank in Denver. "If you've got a lot of experience in global debt you can make a lot of money. If you've just got a certain asset allocation toward global bonds, you might want to be careful with that allocation."

Yet the picture might not get much better in the US, either.

"A lot of the metrics in the credit market are continuing to trend negatively for equities," says Dave Lutz, managing director of trading for Stifel Nicolaus in Baltimore. "People are moving further up the corporate structure to safer assets. You're seeing high-yield getting hit, which is bearish for equities."

Lutz thinks the S&P can drop another 5 percent to the 1,015-1,018 range which would take it to a test of its 200-day moving average.

Indeed, while he and many others in the markets see the sell-off as orderly, that doesn't mean it can't continue.

"There are a lot of things going on with Greece, Portugal, Spain—the weak sisters of the EU—that could turn into a real mess," Twibell says. "It probably pushed this to being a correction, which we desperately needed, to maybe being something a little bit more."