What to Do When the Bull Market Stumbles

Following a stock market correction that seemed to come and go in the blink of an eye, investors are hoping that the worst is behind them—but many aren't convinced. Their anxiety is well founded. To be clear, with no recession on the horizon, we don't think the bull market is over. But more scary downdrafts are likely, and some tweaking of your portfolio may be in order.

Just shy of its ninth birthday, the bull market took a breather in late January and early February, sinking a little more than 10% in less than two weeks. That was the first official correction (defined as a drop of 10% to 19% from a peak) in two years. The downturn may have been exacerbated by a flash-crash-style meltdown in exchange-traded funds that had bet against volatility. But there was nothing mysterious about the fundamental triggers: threats of higher inflation and a rise in interest rates. "The secret sauce of this bull market has been the economy's ability to grow without aggravating inflation or sparking higher interest rates," says Jim Paulsen, chief investment strategist at the Leuthold Group, a market research firm in Minneapolis. "That's changed."

Inflationary pressures are coming from wages that are starting to rise in a tight labor market. More pressure might arise from the fiscal stimulus of tax cuts and increased spending on infrastructure and defense. Yields on 10-year Treasuries jumped from 2.5% in the beginning of 2018 to 2.9% recently, and Kiplinger forecasts that they could trade at 3.3% at year-end. "Now that rates have picked up and the threat of inflation is on the rise, it makes investors less secure in owning stocks at elevated prices," says Sam Stovall, chief investment strategist at research firm CFRA.

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The bull market still has strong underpinnings. Confidence among corporate executives and consumers alike is sky-high, global economies are on a synchronized growth track, and corporate profits—buoyed by lower tax rates—are forecast to increase a remarkable 18% this year. "Once I'm convinced that a recession is coming, it's over. Short of that, a correction is a buying opportunity," says Paulsen.

Another jolt is almost certainly on the way. Going back to 1950, Stovall found 25 calendar years in which stock prices fell by 5% to 20% (more than 20% would be a full-fledged bear market). In five of those years, the market turned down three times, and in three of the years—1980, 1988 and 1997—the market logged four pullbacks of 5% or more. Last year, Standard & Poor's 500-stock index logged one-day price swings of 1% or more on only eight occasions; the law of averages says to expect 50 such days this year.

What to Do

Use the volatility to position your portfolio wisely. Stocks overall will represent good value if the S&P 500 sinks below 2500, says Paulsen. He recommends thinning out interest-rate-sensitive sectors—utilities, real estate investment trusts and telecommunication firms. Focus on stocks that prosper when the economy is growing and inflation is ticking higher, including energy, industrials, raw materials and tech. Consider investing 5% of your portfolio in a commodity fund, says Paulsen. Make sure you have some money invested overseas, where markets are cheaper and economies are growing but far from overheating.

Lastly, think of the recent market mayhem as a dress rehearsal for the next bear market. If your stomach churned and you couldn't sleep at night, it's a sign that you need to reevaluate your stock holdings in relation to your risk tolerance and your stage in life.