Seeking Shelter From the Storm

The market's squall has left no sector unscathed. Where's the best place to run for cover?
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Is it all over now? Or is this the story of the hurricane, with stocks in a brief calm before they start blowin' in the wind?

Paul Desmond, president of market analysis firm Lowry's Reports, approaches stocks strictly from a technical standpoint. From his perch, he has observed a tired old bull market that has appeared to be on its last legs for some time now. For him, that bull keeled over on Wednesday, May 17, when the

S&P 500

shed 1.7% on a day that saw 90% downside volume. A bear rose in its place, clawing at investors' gains for the year.

"I'm just sort of a weatherman who can tell you that dark clouds are forming in the markets," says Desmond. "What caused them to form? I don't know, but it's going to start raining here and raining hard in a short time."

If he's right, investors should be looking for shelter from the storm. Where should they go?

At the end of 2006, the CBOE Market Volatility Index had been in a steady decline since 2003. For the first half of this year, it was bouncing around just above its all-time low. When the May selloff began, it spiked up near a two-year high, prompting some observers to conclude that the index is in the process of reversing course and that a major shift in market psychology is at hand.

"You could always buy some in-the-money call options on the

CBOE Volatility Index as a hedge against more downside," says Barry Ritholtz, chief investment officer with Ritholtz Capital Partners and a

RealMoney.com

contributor.

Ritholtz has long warned investors of the dangers of inflation, and he characterizes Wall Street's inclination to ignore soaring energy prices as "ridiculous."

"It's clear to anybody who owns a small business or actually goes out to the stores and purchases things that everything has gone up in price in the last few years," he says. "Our economy is flexible and resilient enough that even if the

Fed

tightens too far and causes a slowdown, we'll bounce back from it. On the other hand, if inflation gets away from them, it becomes a wildfire, and that's a much worse scenario."

Given the rising demand for oil in Asia, Ritholtz says energy stocks such as

ConocoPhillips

(COP) - Get Report

and

BP

(BP) - Get Report

remain a safe haven, despite their spectacular run of late. He also believes that the rise in other commodities, such as gold and other precious metals, could continue even if a short-term correction occurs, providing investors with another hedge against the stock market.

Hugh Johnson, chief investment officer with First Albany, takes the opposite tack. He says the Fed may have already gone too far, having raised interest rates by a quarter-point 16 times in a row, but the results might be the same.

"Could this be the start of a bad time for the stock market or a bad time for the economy? Absolutely," says Johnson. "Do I have a definitive signal that such a shift has occurred? Not yet, but I'm close."

He views commodities as a danger zone, since price increases there have already reached "speculative levels," and the market is showing signs of unwinding, as evidenced by the downturn last week. He says investors should consider reducing the commodity allocation in their portfolio to stocks, particularly those of basic materials and industrial companies like

Alcoa

(AA) - Get Report

,

Phelps Dodge

(PD) - Get Report

and

Newmont Mining

(NEM) - Get Report

.

He says investors could also shift the remains of their stock portfolio to bear-market sectors like consumer staples and utilities. These are areas that serve society with the bare necessities in life. In an economic downturn, they would likely be the last to suffer.

"We're not going to take these steps until the market hits our trip wires, but we're thinking about doing them now," Johnson says.

Investors should also look abroad to foreign market funds for some diversification, but in today's globalized economy, a slowdown in the U.S. doesn't bode well for its many trading partners either.

The average decline for the S&P over the last 11 bear markets has been 30%, but Desmond says that even more pain is in store this time around.

"This drop could be bigger than that because this market has been dominated by mid-cap and small-cap issues," Desmond says. "They're generally illiquid stocks that are easy to get into in a bull market, but tough to get out of in a bear market. That could exacerbate declines."

The rise in smaller-cap stocks that persisted even through the bear market of 2002 may explain what Mark Sellers, managing partner with Sellers Capital, says is a recent bias toward "low quality" issues. So far this year, stocks that are given a C rating by Standard & Poors have more than doubled the performance of stocks with an A rating. That means investors have gravitated toward buying sexier companies that also tend to have higher debt levels, lower cash flows, less proven management teams and more speculative business models.

It may sounds boring, but Sellers recommends buying shares in large-cap market leaders with clean balance sheets, consistent cash flows and dependable managers. He points to stocks such as

Microsoft

(MSFT) - Get Report

,

Procter & Gamble

(PG) - Get Report

and

General Electric

(GE) - Get Report

.

So far, no sector of the stock market has been spared in the selling. Technology looks particularly vulnerable, with the Philadelphia Semiconductor index down almost 10% in May. The Amex Networking index has shed more than 6% for the month.

"My real concern is for those investors that are loaded up with mid-cap and small-cap stocks," Desmond says. "They really need to be alert because those stocks are extremely volatile during bear markets."

That said, he cautions investors against pinning their hopes on any one sector in the stock market. Bonds are viewed as the classic diversification to stocks, and investors can always lock in the 5% risk-free return on the 10-year Treasury bills if they're willing to hold the notes to maturity. But Lowry's research shows the bond market appears to be in a bear market as well, and if rates keep rising, bond prices will be dropping.

"I think a large percentage of the portfolio just has to go to short-term money market positions," Desmond says. "In the history of bear markets, the places that you can hide are all temporary. There will be a period where some sector or segment of the market is holding up fairly well, but then it will break, and when it breaks, it will break badly."

By then, investors won't need a weatherman to tell them which way the wind blows.