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As Investors Return to Market, Stocks Are Facing Volatile Fall

After Labor Day is traditionally the time when investors come back to the market. And if that holds true this year, it could mean volatile times ahead.

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After a sleepy summer that saw the indexes climb higher on mostly anemic volume, the early read on the first month of autumn is indicating a return from retail and long-term investors.

While high volume is often seen as a sign of conviction in the markets, the difficulty of sustaining a six-month rally coupled with conflicting signals on the state of economy could make for a bumpy ride, market pros say.

"There's still a large amount of cash sitting on the sidelines because people haven't believed that this rally is for real," says Don Bertrand, vice president of WealthTrust-Arizona in Scottsdale. "Volume and volatility have been relatively low through much of the summer. If volume does pick up, I think that may mean volatility is going to pick up as well."

That could mean tough choices as to how committed investors want to be to a market that has already rallied about 50 percent off its March lows.

For Bertrand, the climate demands some exposure—about 40 percent—to equity-based investments, but a large allocation to bonds and alternative investments that don't correlate to stock indexes. He's using private real estate investment trusts (REITs) and managed futures as shelters away from what could be a volatile stock market.

"People are still scared to death," he says. "The average investor lost a ton of money last year. If they do have cash they're not putting it back in the market in any meaningful way. They're still taking a wait-and-see approach."

Yet that money will have to go somewhere, as short-term Treasurys are yielding near zero while money markets and other cash havens are providing extremely low returns as well.

Money managers and portfolio advisers are likely, then, to come back into the market, but will be buying protection against both upside and downside market moves that would come from emotion-driven investors.

The Chicago Board Options Exchange's Volatility Index , which measures fluctuations in the Standard & Poor's 500, has been in a fairly tight 25-30 trading range over the summer and is about a third of its level during the worst of the 2008 credit collapse.

Options traders are buying VIX futures at around the 31 level for October, but a surprise from economic data points or earnings pre-reporting could easily change that. And a level above 30 indicates significant volatility anyway.

Indeed, investor behavior seems to be in flux, and portfolio managers worry that when the heavier September volume comes in the market, a correction could get accelerated by emotions.

"My biggest concern is that if the retail investor moves in now with a passion, are they going to understand that it's not infeasible for the market to correct?" says Michael Kresh, president of M.D. Kresh Financial Services in Islandia, N.Y. "I'd rather see them moving in during a small correction than near their highs and then panicking if we saw a moderate fall in September."

Market experts increasingly have been warning of signs that the economy faces hard times ahead.

Pimco co-CIOs Bill Gross and Mohamed El-Erian, who run the largest bond fund in the world, said 2010 could pose a "double-dip" for the economy. Famed economist Nouriel Roubini is predicting a U-shaped recovery, with a prolonged run along the bottom, while a double-dip is possible. Dallas Federal Reserve President Richard Fisher warned Thursday of a muted recovery, echoing other cautious statements from central bank officials.

Such prospects have market pros on their toes to guard against sudden swings in the market once the mid-level investors step back in. The summer's rally was driven in large part by institutional investors and traders, with a stronger test on its way as 2009 enters its stretch run.

"When you come into the earnings season, volatility moves up," says Quincy Krosby, general market strategist at Prudential Financial. "It's always at points like this you can have surprises as much to the upside as you can disappoint to the downside."

Kresh says he's not moving to any new investment positions but is rather mostly building current spots.

Any investor coming into a market like this should be prepared for the long haul and not be ready to pull back on the blips of volatility, he says.

"If the market corrects 8 to 10 percent and it doesn't do it very violently, that would be an excellent time for retail investors to come in," Kresh says. "If they come in now and we get another rush, that would give us all these months since March without a pullback. That pullback will be sharp, and if that pullback is sharper than expected the skittish investors will jump ship."