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Market takes investors on a wild ride

Jitters in Shanghai jangled markets worldwide last month – a wake-up call for investors to keep a closer eye on the downside.

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With profits growth sputtering, the best long-term values are in the large-cap arena, says Michael Maubousin, chief strategist for Legg Mason Capital Management. Companies such as General Electric and United Technologies have greater exposure to global growth and pricing power than small companies do, he says. They also benefit from an upswing in US exports, aided by a weaker US dollar. Large-cap growth stocks are "statistically cheap when compared to large-cap value stocks," agrees Eric Bjorgen, senior analyst with Leuthold Group in Minneapolis. "But you need to see more positive sentiment toward the healthcare and technology sectors before growth funds forge ahead."

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Investors need to keep a sharp eye on the financial-services sector, which is close to 25 percent of the total market capitalization of the S&P 500, analysts say. "Banks face their toughest environment in five years," says Lester Satlow, portfolio manager with Cabot Money Management. "Consumer loan growth has peaked, lending standards on mortgages are tightening, and credit quality is deteriorating. In 2006, the financial sector provided more than one-third of the S&P 500's earnings growth. It won't be nearly "the same kind of earnings engine" this year, he says.

The bull market that began in 2003 may be struggling, but don't expect its demise anytime soon. An economic slowdown, coupled with sluggish profits growth, are by themselves not likely to trigger a bear market, analysts say. The traditional warning signs – a severe narrowing in stock-market breadth, rampant optimism, and extended valuations – are not evident, says Leuthold's Bjorgen. The more likely result is a choppier market with a shift in leadership away from cyclical industrial stocks toward higher quality, dividend-paying stocks in more stable industries.

Adam Bold, chief investment officer for the Mutual Funds Store, a chain of mutual fund advisory offices based in Kansas City, Kan., agrees. "You're seeing a healthy correction in progress, but not the beginning of a bear market," he says. Investors need to be more alert to managing downside risks, he says, but not react emotionally by retreating. In recent months, client portfolios have reduced small-cap and international funds holdings in favor of funds emphasizing large-cap, multinational companies. An investor nearing retirement may well have more than 50 percent of his or her portfolio in equities, but it should be properly diversified, he says. "We always determine the appropriate asset allocation first, and then pick funds with proven track records. Too many investors do it the other way around."

Market strategists enter the second quarter in a wary mood. "I'm looking for a modest spring rally with some speed bumps along the way," says Fred Dickson, market strategist for D.A. Davidson. Consumers may be stretched financially, he says, but job and income growth continue to buoy spending. While the housing slump is likely to continue to be a drag on the economy, GDP growth will probably still exceed 2 percent for the year. Another positive factor: Equity shrinkage of 5 percent in 2006, the upshot of record stock buyback activity, has put lots of money on the sidelines, waiting. Over the next few weeks, he expects market action to be heavily influenced by first-quarter earnings reports, which may well contain some negative surprises.

Income-oriented investors, meanwhile, should stick to high-grade, short to intermediate bond funds, bond experts say. Don't buy long-dated bonds, since these could lose value quickly if inflation numbers sour. "High-yield bond funds have had a good run," says Jason Brady, bond fund manager with Thornburg Investment Management in Santa Fe, N.M., "but you're not being paid for the added risk at this point in the cycle."