Is This Bull Over?

Is the market finally coming to terms with the significant macroeconomic risks that are hiding in plain sight? Last Thursday's 3.1% loss in the S&P 500 could be a sign that the overextended rally we have experienced has finally run out of steam. If the beta trade (i.e., riding the market up) is coming off the tracks, investors need to position themselves correspondingly.

In the most recent issue of his widely followed quarterly letter, GMO chairman Jeremy Grantham puts the S&P 500's value at 850 (it closed north of 1,050 yesterday). That looks like a reasonable estimate: According to data compiled by professor Robert Shiller of Yale, it's equivalent to 15.7 times average inflation-adjusted earnings over the prior 10 years -- in line with the multiple's historical average (16.3) going back all the way to 1881. Using Grantham's fair value as a benchmark leaves plenty of room for the market to correct further.

The sector square dance
Here's another sign that risk aversion has returned, depriving the rally of the buying power that fuels it: From the market bottom set on March 9 through the end of 2009, the top three performing sectors were all cyclical. On a year-to-date basis, that ranking looks decidedly more defensive:

Top S&P 500 Sectors, % Return

Rank	2009 (March 9 - Dec. 31)	2010 (Year to Date*)
No. 1	Financials (+131.3%)	Health Care (-1.3%)
No. 2	Consumer Discretionary (+87%)	Industrials (-1.9%)
No. 3	Information Technology (+85.7%)	Consumer Staples (-2.1%)

Source: S&P Indices.
*As of Feb 5, 2010.

Although Financials aren't by any means the worst-performing sector this year, a number of large financial shares have already corrected significantly, judging by the discount to their 52-week highs, including AIG (NYSE: AIG  ) : -60%, Morgan Stanley (NYSE: MS  ) : -24%, Goldman Sachs (NYSE: GS  ) -20%, JPMorgan Chase (NYSE: JPM  ) : -19%, and Capital One Financial (NYSE: COF  ) : -19%.

Preparing for a correction
Investors should be underweight U.S. stocks if the bulk of their exposure is through index funds such as the SPDR S&P 500 ETF (NYSE: SPY  ) . Investors in individual shares should be particularly careful that the stocks they own are priced with a genuine margin of safety and/or belong to the highest-quality businesses. Finally, "defensive" and "opportunistic" can go hand in hand. Volatility is likely to increase, ushering in risk -- and opportunity (for those who come prepared).

Investors shouldn't expect any significant gains from U.S. stocks this year; however, Global Gains co-advisor Tim Hanson has found a way to earn 50% annual returns.