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Equity Pullback in the Cards but Outlook Will Brighten Later This Year

NEW YORK (TheStreet) -- Markets are at risk of a near-term pullback before stronger second-half gains are made amid better economic data and earnings.

That's the assessment from fund managers, after a sideways slide in stocks this year painted a sharp contrast to the rally of 2013.

The S&P 500 has gained just more than 3% this year, as markets take a breather after the rise in valuations while last year's outperformers -- small caps, biotechs, new media and consumer discretionary -- are sold off for less expensive sectors.

"The first half has been about digesting last year's gains and now further gains will be driven by earnings and economic news," Warren Financial chief investment officer, Randy Warren, said in a phone interview.

Chase Investment Counsel chief investment officer, Edward Painvin, suggested the sideways slide could continue over the summer months, and sees no indicators of a sharp move either way in markets.

"Second-quarter earnings in July will be very important," he said, noting many companies had forecast stronger earnings in the second half.

The ongoing unwind of Federal Reserve bond purchases, which has fueled demand for equities, will make stocks more sensitive to fundamentals, fund managers said.

Some are circumspect.

RockWell Global Capital chief market economist Peter Cardillo pointed to a 14-month low in the VIX -- a key indicator of market volatility -- as a sign investors may be too complacent over geopolitical risks. If any eventuate, markets could be shaken near-term, he warned.

"Volume is also not great, but any pullback shouldn't be too serious," he said. In the medium-term, Cardillo said he expects better economic data to support new market highs over the summer to around the 2000-range.

BlackRock's Global Chief Investment strategist Russ Koesterich echoed concerns over low volatility. "The market may be vulnerable to a slide should there be any outside shocks - a possibility with key elections taking place in Europe and Ukraine," he said. "We would exercise a bit of caution in the near term and focus on areas of the market that offer good value and downside protection."

Option activity also indicates skepticism around near-term gains: S&P 500 call options which enable investors to buy the index at a point in future are at their cheapest level in a year, Credit Suisse noted. This means investors see little upside for a market that has already rallied hard.

In addition, many traders point to a lack of breadth in the rally as evidence of its fragility: Only 5% of S&P 500 stocks are hitting their 52-week highs compared to far broad participation a year earlier.

Some strategists warned that the prospect of additional stimulus from Europe to lift inflation could be counter-productive.

"What central banks may not realize is that their policy is hindering a rebound in inflationary pressures, as wages have not kept pace with house prices, principle repayment and cost of living pressures," said Matt Sherwood, Perpetual's head of investment research.

He said this meant no clear rise in consumer price inflation was possible, which would make it harder to solve any government debt crisis. "Despite record share prices, investors need to remain cautious and focus on strong balance sheets and robust operating models," the Sydney-based strategist warned clients. 

Cardillo said further strength from small caps will also be key to any ongoing rally. Small caps are viewed as an indicator of risk appetite and have shed 0.74% this year, underperforming the broader market after posting 33% in 2013. Similarly, financials have failed to outperform, with strong sector performance viewed as necessary if markets are to push higher.

Stocks which illustrate a reversal of sector fortunes include Citigroup (C) and JP Morgan (JPM), which gained 26% and 31%, respectively, last year and have shed 8.7% and 5.7% in 2014. Many new tech, biotech and retail stocks have moderated their returns: Twitter (TWTR - Get Report) has shed 52% this year after rocketing 144% in 2013, Gilead Sciences (GILD - Get Report) has gained around 9% after jumping 100% last year and Macy's (M) has added 8% after posting 40% in 2013. 

All up, reasons for caution in the near-term, but a seemingly brighter outlook ahead.

-- By Jane Searle in New York 

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