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Published: Jul 08, 2014 5 min read

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Jason Hindley

From a certain angle the stock market sure looks sweet. Both the S&P 500 index and the Dow Jones industrial average are setting new record highs seemingly on a daily basis. The number of winning stocks also continues to swamp the losers, historically a sign of strength for equities. Yet if you look at the market from a slightly different vantage point, you’ll start to see blemishes. During one stretch from early March to mid-May, for instance, the Russell 2000 index of small-company stocks slid more than 9%, while the fastest-growing companies in that part of the market slumped nearly 13%. Plus, among the worst performers were last year’s biggest darlings: biotech and social media stocks. “We’re in a stealth correction,” says Craig Johnson, managing director at Piper Jaffray. He thinks the damage could bleed into blue chips as well. Why? In the past, when small stocks significantly lagged large-caps, there’s been a broad selloff—with typical losses of 12% for the S&P 500. Plus, a pullback is overdue. A stock market correction—defined as a loss of 10% to 20%—occurs on average every 26 months, according to InvesTech Research. We’re now at month 32 and counting. Markets like this can be tricky because it’s difficult to tell how much defense to play. For instance, while Johnson cautions of the possibility of a near-term slide in the broad market, he expects the S&P 500 to end this year 8% above its early June level. History offers you clues to the key dos and don’ts: Don’t assume a correction will lead to a bear Small-stock weakness led to major pullbacks for the broad market in 2011, 1999, 1998, 1997, 1996, and 1994. None of those years, though, witnessed full-fledged bear markets, defined as a 20% or more decline in stock prices. “The case for the bull market to continue remains surprisingly firm, given how far we are in this expansion,” says James Stack, president of InvesTech Research. Among positive economic signs: rising consumer confidence and manufacturing, combined with a still-stimulative Federal Reserve. Do seek a smoother ride The market has been about as steady as it’s been since before the global financial crisis. So what’s the point of tilting toward low-volatility stocks, shares of companies that bounce up and down less than the broad market? Well, AllianceBernstein took a look at global stock performance since 1989, comparing the broad market against the slice of stocks with below-average rockiness. In months when the broad market lost value, “low vol” outpaced the rest of the market 83% of the time. This strategy has been popular lately, so the stocks aren’t all cheap. Go with low-cost ETFs with portfolios sporting relatively attractive valuations, such as PowerShares S&P 500 Low Volatility (SPLV) and iShares MSCI All Country World Minimum Volatility (ACWV). Don’t buy the small-cap dip While small-company stocks have been beaten down, they remain expensive. Small-cap shares have historically traded at about the same price/earnings ratio as the S&P 500, based on five years of median profits. Today they’re 35% more expensive. Also, when blue chips falter, small-caps tend to fall more. “This late in the bull, I’d be taking profits in small-caps and focusing more on large-cap stocks, which represent better value,” says Doug Ramsey, chief investment officer of the Leuthold Group. Do focus on late-stage winners “I don’t know if we’re in the seventh inning, the eighth, or the ninth,” says Ramsey. “But I do know it’s one of those—and late stages of bulls are different.” In the final 12 months of past bull markets, for instance, energy, tech, and health care stocks have typically thrived (see chart). For exposure to these sectors, InvesTech recommends Conoco­Phillips (COP), Qualcomm (QCOM), and Express Scripts (ESRX). If you prefer a mutual fund, Money 50 pick Primecap Odyssey Growth (POGRX) has 70% of its stock portfolio invested in health care and technology, double the S&P’s exposure. Sound Shore (SSHfX), another Money 50 pick, also has a bigger-than-average exposure to these three key areas. What if this isn’t the bull’s final year? No problem: Over the past three years, Sound Shore has delivered 115% of the S&P 500’s gains in periods when the market is up, according to Morningstar. So either way, you win.