Hard Times Investing: Headwinds Ahead For US Stocks

Investors concerned about economic growth.

Corporate earnings may be bright spot.

Midterm election usually a downer for stocks.

Domestic stocksthese days are about as stable as a kite in a wind storm, diving and climbing with such gut-wrenching speed that it’s virtually impossible to predict which direction they might turn next. And by all indications, there won't be calmer skies anytime soon.

Sandra Baker | Photographer's Choice | Getty Images

While investment strategists generally expect US equities to close out 2010 in negative territory with a likely rebound early next year, most also say the market between now and December 31 remains too unpredictable to forecast with any confidence.

Indeed, there’s much that could rattleinvestors in the months ahead.

After a series of disappointing reports on jobs, housing and manufacturing earlier this year, for example, third- and fourth-quarter economic data will carry significant weight as Wall Street looks for signs the economy is continuing its expansion despite the financial crisis in Europe.

“I think investors will most certainly be focusing on the growth of the economy, which right now we regard as a half-speed recovery,” says Sam Stovall, Standard & Poor’s chief investment strategist. “It’s growing at about 3 percent compared with the more normal 7 percent we usually see during the early part of an economic expansion, so there’s still a question as to whether we have finished with this correction.”

Corporate earnings, meanwhile, may also provoke the bulls or the bears, shedding light on whether key sectors of the U.S. economy can maintain their recent momentum (including banking, energy, and information technology) and more importantly whether corporate growth might spur job creation—the Achilles heel of the thus-far lackluster recovery.

Political Factor

And then, of course, there’s themidterm election.

Historically, the market’s sweet spot during the four-year presidential cycle is the fourth quarter of the midterm year and first quarter of the pre-election year, according to the Stock Trader’s Almanac. That suggests the markets may get a boost between October 2010 and March 2011.

Since 1949, in fact, the Dow Jones Industrial Average has averaged 14.4 percent during those two quarters, while the S&P 500 index averaged 15 percent. The Nasdaqhas averaged 24 percent during that 6-month period since its inception in 1971.

More impressive still, however, the Almanac reports the Dow has rallied a whopping 50 percent on average from its midterm year low to its pre-election year high.

“After a likely midterm bottom before the elections, I expect a big rally to ensue with a new recovery high, but not all-time high, sometime in 2011,” says Jeffrey Hirsch, editor-in-chief of the Stock Trader’s Almanac.

Stovall agrees.

His analysis shows that midterm election years have been challenging for stocks since 1962, when the median market decline from the start of the year to its 52-week low was 16.4 percent.

“The bottoming point [during midterm years] usually occurs in October, which then sets us up for a very nice potential rally in November and December allowing for a good fourth quarter and a running start to the next year,” says Stovall.

In the year following midterm elections for the last five democratic administrations, he adds, the market was up five times, rising an average 21.3 percent.

Buy or Hold?

Does that mean average investors should overweight their portfolios on domestic stocks in the next few months?

"“You don’t want to become a forced seller. Keep your emergency fund in cash and cash-like vehicles." -Moringstar, Paul Larson

Not unless you’re partial to risk, says Paul Larson, an equities strategist with mutual fund tracker Morningstar in Chicago, noting market timing strategies are best left to seasoned professionals.

“Try and maintain a long-term view and avoid short-term market calls, which no one has been able to do with any success,” he advises.

Over the next few months, Larson says investors should check their portfolios to be sure they haven’t invested any money they might need over the short term into stocks – domestic or otherwise. That, and continue to reinvest dividends as appropriate.

“You don’t want to become a forced seller,” he says. “Keep your emergency fund in cash and cash-like vehicles, not so much Treasurys today. They’re not giving an adequate return for the risk [of inflation eating away at your return down the road.]”

According to Stovall, a back to basics approach to investing and realistic expectations for long-term returns are more important than ever these days given the volatility on Wall Street.

“We all learned a valuable lesson about not going too far out on the risk curve,” he says. “I still think investing is the best way to outpace inflation, but there are times in history where the market goes through extended sideways periods—the last one being from 1966 to 1982. I think we’re in one of those now so investors should be aware of that.”

Hunting For Value

That said, however, there’s no shortage of buying opportunities for value investors and those looking for more speculative bets outside of their retirement portfolios.

According to Morningstar, for example, the average stock in the healthcare sector is about 15 percent undervalued.

“This is a sector where we’re finding a fairly large number of attractive stocks,” says Larson. “ There’s a lot of uncertainty right now regarding how healthcare reform legislation will effect the space and that’s probably why this sector is out of favor among investors. But based on the raw cash flow these companies are producing, we think there are a significant number of values in this space.”

For example, Larsen points out that Novartis has a fair value estimate of $71 but is currently trading at less than $50, while Johnson & Johnson , with a fair value of about $80, is also on his list. The blue chip stock is trading at around $58.

For his part, Hirsch says he’s still waiting for the proverbial “fat pitch,” or better values, before jumping in, but notes he has his eye on alternative energy exchange traded funds, ETFs. Among them: Claymore/MAC Global Solar . FirstTrust Global Wind Energy ,Market Vectors Nuclear Energy and PowerShares WilderHill Energy .

He also favors dividend-paying stocks with a track record for increasing dividends, something Stovall says he’s come to appreciate as well.

“It’s what mom always told you,” he says. “It’s worth paying for quality.”