Risk of Stock Pullback Continues

Investors breathed a sigh of relief last week as major stock indexes recovered almost all their recent losses. Talk of a major downdraft faded.

Many money managers warned clients, however, that the risk of a sharp pullback has been delayed, not eliminated. Stocks still are expensive after last year's huge gains, making it hard for them to keep rising as the Federal Reserve reduces its support. The S&P 500 stock index last year rose 32% including dividends, its biggest gain since 1997.

"We continue to think we are going to see more volatility than we have in the past," said Jim McDonald, chief investment strategist at Northern Trust, which manages $915 billion in Chicago.

Markets have been so strong in recent years that major indexes haven't dropped 10% or more since September 2011. That is twice as long as usual. "Investors need to be positioned for that to happen at some point this year," Mr. McDonald said.

He is telling clients to keep needed cash in short-term and medium-term bonds, rather than in stocks.

So far, indexes have escaped the declines many money managers expect. The Dow Jones Industrial Average fell 7% in January and early February and the S&P 500 dropped 6%, but both rebounded. Neither fell even 4% in the latest selling.

"I was a little surprised that we bounced back as quickly as we did" this month, said Jim Dunigan, chief investment officer at PNC Wealth Management, which oversees $130 billion.

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"I still look at this year as a transition period, from a market that was supported by easy money, by highly accommodative monetary policy, back to one that is based on fundamentals," he said. "All transitions are challenging but this will be sloppy to get through."

Because the Fed and other central banks have been holding interest rates low and stocks have been rising for so long, investors have forgotten what a normal market looks like, Mr. Dunigan said. As the Fed slowly allows interest rates to rise to more-normal levels over the next few years, he and others said, markets are likely to see more-normal volatility.

In an average bull market, the S&P 500 falls by 10% or more about once every 16 months, according to Ned Davis Research. It has been 31 months since the last 10% pullback, in September 2011.

The strains are showing. The Dow closed at a record 52 times last year but hasn't hit any records in 2014. The S&P 500 has hit eight records this year, after 45 last year. At the end of last week, the Dow was down 1% for the year and the S&P was up 0.9%, far from last year's pace.

Last year, the S&P 500 fell as much as 2% on only two days; it already has done so three times this year, says Mr. McDonald of Northern Trust.

Stock prices are high by historical standards, although not off the charts.

The S&P 500 trades at 16 to 18 times its component companies' earnings, depending on how the earnings are measured. That is above long-term averages of 15 to 16. At this level, stocks sometimes but not always have suffered declines. But the current price/earnings ratio is nowhere near the 35 to 40 range reached at the height of the 2000 tech-stock bubble.

A much-followed P/E measure maintained by Nobel Prize-winning Yale economist Robert Shiller, based on 10-year average earnings, is now well above its average historical level. But it isn't quite as high as when markets peaked in 2007 and is far from its 2000 level.

While fears of a decline are widespread, few money managers expect it to be severe or long lasting. One big reason: The Fed is determined to avoid recession and to keep financial markets stable, and investors feel it is foolish to fight the Fed.

Money managers increasingly are adopting a view dubbed "Tina" by Jason Trennert, founder of Strategas Research Partners. Tina stands for "there is no alternative" (to U.S. stocks).

Low interest rates are keeping some people from buying bonds. Although U.S. stocks are more expensive than European ones, many consider the U.S. economy stronger and safer. And with developing economies like China, Brazil and Russia facing problems, many U.S. investors are wary of those stocks.

"Where are you going to put your money, in cash at zero interest? Emerging markets still are suffering from their malaise and U.S. equities are looking kind of like a safe haven," said Janna Sampson, co-chief investment officer at OakBrook Investments, which oversees $3.3 billion in Lisle, Ill.

Ned Davis Research has been warning for months that stocks could face a pullback in the middle of this year. It says the risks will heighten if stocks keep rising and investors become overly optimistic again. But its analysts, too, forecast that declines will be limited.

"Deeper bear markets generally are due to recessions," said the firm's global strategist, Will Geisdorf. Because the Fed is so supportive, "we see little threat of recession until 2016 or 2017."

Some investors are saying the market might escape a 10% decline this year. Instead it could suffer smaller pullbacks, as it already has been doing. Some term that a "sideways correction," meaning one where stocks don't fall heavily but fail to make significant gains for a long period.

One likelihood is that markets won't do what most analysts expect. Big pullbacks come when investors are overly optimistic and aren't expecting trouble. They stop hedging, move too heavily into stocks, get caught off guard by a decline and panic. Right now, it would take a sudden, unexpected shock to cause that kind of reaction.

Related: E.S. Browning has details on MoneyBeat.