Second-Half Investment Guide: Riding Market Volatility

Stocks have enjoyed a nice run so far in 2007 and market strategists are predicting further gains in the second half of the year, but Wall Street experts say investors should expect further market volatility.

There are a number of potential risks which could affect the market in the back half of the year and include another spike in energy prices, housing worries, the potential for geopolitical blowups and, of course, what the Federal Reserve decides to do about interest rates.

Stocks got off to a strong start on the first trading day of the third quarter, with the major indices postings gains of about 1%.

The market should end the year above current levels, say market pros such as Goldman Sachs chief U.S. portfolio strategist Abby Joseph Cohen, who is forecasting the S&P 500 to end the year at 1600, translating to broad market gains of about 6%.

"It's based upon the idea that profits are good and that 2008 will be another year of economic and profit growth," Cohen told CNBC.

"Without a doubt in my mind, the bloom is not off the rose and the market works higher," says Vince Farrell, managing director at Scotsman Capital Management. "Valuations are reasonable, interest rates although up a little bit are perfectly moderate in the longer scheme of things."

"I think the rest of the year plays out in a bumpy fashion but by the end of the year you're going to have stock prices up commensurate with earnings increases, which is going to be in the very high single digits," adds Farrell.

The major indices have been surprisingly resilient this year, posting solid -- if not spectacular -- gaiins. Despite a volatile second half of June, the Dow Jones Industrial Average gained 7.5% in the second quarter while the S&P 500 added 5.8%.

The energy sector has performed extremely well this year with returns of 17% year to date, with the bulk of gains posted in the last three months. Integrated oil giant Exxon Mobil is the most heavily weighted stock in the energy sector, followed by rivals ChevronTexaco and ConocoPhillips.

Meanwhile, basic materials has performed just as well as energy, powered by huge gains for metal mining companies such as Alcoa and Freeport-McMoRan, in addition to solid returns from commodity chemicals company Monsanto.

Underperforming sectors were led by the financials, the only group currently sporting a year-to-date loss, albeit modest a 0.7%. Citigroup and American International Group are both down for the year. Other laggards include consumer stocks -- both staples and discretionary -- as well as the health care sector.

Tom Schrader, managing director of U.S. listed trading at Stifel Nicolaus, says current trading action remains choppy and the market is in need of a correction but should move higher in the second half.

"We need to scare some people and we need bring back some of the fear into the market to bring back valuations," Schrader says.

The head trader notes that the heart of the summer season is "generally not such a good time" but trading usually picks up in late summer.

"The second half of the year, on a calendar basis, tends to be pretty good time to be invested," he says. "It's a good time to put new money to work."

Watching the Weather

Schrader says one potential overhang on the market has to do with, of all things, the weather.

"If we get bad hurricane weather this year and gas and oil prices spike up you might have to throw the baby out with the bath water," he says. "But barring a tremendous hurricane season, I think we'll do OK going into the end of the year.

Brian Hicks, editor of the investment newsletter Wealth Daily, says investors should capitalize on energy trends. He focuses on energy stocks and expects the group to continue to perform well despite expectations for continued volatility in both commodities and energy stock prices.

"You're seeing a lot of money being invested being invested into energy right now," he says. "We're in a nubile market, when you have the major indices making record highs and trading near record highs there tends to be more risk capital going into the public markets. Energy, as a sector, is still outperforming the major indexes."

Fed Also In The Picture

The most recent annual report from energy policy advisor International Energy Administration found that $20 trillion will need to be invested in the energy-related infrastructure over the next 25 years in order to meet surging demand.

Hicks recommends investing in oil refiners and oil services firms.

One stock he likes and owns is Legacy Reserves , a company which focuses on the Texas oil patch, which has been abandoned by Big Oil because of what were once high production costs. Two barrels remain in the ground, Hicks contends, for every one barrel of oil that has been drilled and removed.

Todd Schoenberger, director of brokerage at financial services firm USAA, says higher oil prices will take their toll on consumer spending and investors should therefore avoid consumer discretionary and retail stocks.

"It's no secret that if the U.S. consumer has to pay $3.50 to $4.00 at the pump that means less money for them to buy consumer products," he says. "That will also affect U.S. retailers."

Nevertheless, Schoenberger, whose firm prohibits him from naming individual stocks, expects the markets to close the year with gains.

"You have to be bullish on the markets and it's a good idea to stay that way until we see some changes from the Federal Reserve," he says.

Hold Steady if Fed Remains Steady

"It's hard to think the Fed is going to do anything. Right now we're seeing some GDP forecasts approaching 3%, but 2% to 3% is very healthy," says Schoenberger. "It might be difficult for the Fed to make changes at this point but either way, their stance is going to direct the short-term direction of the market."

Fluctuating yields on the Treasury's ten-year note, which is now above 5.00%, contributed to recent market volatility but Nasri Toutoungi, a fixed income fund manager at Hartford Investment Management, does not expect the Federal Reserve to raise its federal funds rate because inflation is moderating.

"We don't see tightening in the cards," says Toutoungi, portfolio manager for the Hartford's Total Return Bond Fund. "Inflation looks like it's coming down and the economy is stable so the Fed is more likely than not to ease."

The bond manager says although he is buying ten-year Treasuries on dips in prices, which move inversely to yields, he is staying away from the U.S. fixed income market and is focusing on corporate bonds in emerging markets.

High-yielding notes in countries such as Brazil, Argentina, Thailand and Turkey continue to look attractive, he says.

Mega-Cap Safe Haven

Subodh Kumar, chief market strategist with Kumar and Associates, says equity investors should focus on protecting their portfolios by investing in the biggest of the big companies, or the so-called mega cap stocks.

"We think in a difficult environment they are going to do the best," Kumar says. "They've had a stealth rally and have been doing better over the last year."

USAA's Schoenberger expressed a similar sentiment.

"I think smart investors look at historical data, and if you look at the past 60 years you'll see that large cap stocks outperform all other asset classes," he says.

Large-cap industrial stocks, says Kumar, "will perform pretty well here." He named General Electric, parent company of CNBC and CNBC.com, as an example.

"Investors are embracing cyclicals now," he adds, "this isn't where utilities will run away from the market as they did the early part of this year. This rally so far has been really about the technology sector; I think those sectors are going to continue to move higher."

Kumar says cyclical sectors such as industrials and certain technology industries are at "relatively attractive valuations."

"They're kind of giving this market its second wind," he says. "Remember, these aren't the sectors that got us here. It was more energy utilities, telecom, big leaders -- we have fresh leadership in this rally and new buyers are starting to come back to the market."