A Stock Market Correction May Have Begun

Investors are worried about a Federal Reserve policy shift--and many other things.

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For a few weeks, Wall Street analysts have been wondering what it might take to trigger a stock-market selloff.

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They may now have the answer. The minutes of the Federal Reserve's January meeting show that some central bank officials are growing skittish about the aggressive monetary stimulus policies the Fed has been pursuing since late 2008.

As usual with the Fed, that's not really news, but some investors felt they detected a shift in emphasis that could mean an earlier end than expected to policies that have helped inflate stock values. The day the minutes were published, the S&P 500 index fell by more than one percent, the sharpest drop of the year.

The Fed update, however, may have been more of a pretext for selling than anything else.

"Many pundits are pointing to the minutes as the cause of the selloff, but that looks more like a convenient excuse," writes Patrick O'Hare of Briefing.com, a financial research firm. . He points out that it took traders longer than usual to react to the Fed minutes, while other indicators, such as Treasury rates, didn't react as they normally would have to a "hawkish" shift at the Fed.

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The stock market, meanwhile, has begun a pullback that looks like it could be the start of a 5 to 10 percent "correction" some market analysts have been warning about. In a recent note to investors, Bank of America Merrill Lynch highlighted three reasons a pullback may be likely.

First, investors may have become too complacent about risks that could push stock prices down, such as shocks related to the forthcoming "sequester" in Washington, or to ongoing debt problems in Europe. The economy has been surprisingly resilient lately, but that doesn't mean it will continue to shrug off negative developments that have real economic consequences.

Second, the Fed may be tacitly signaling that investors should start preparing for the end of quantitative easing and other monetary stimulus measures. Nobody expects an abrupt shift in Fed policy, especially since the Fed has made efforts to become more transparent about its intentions, not less. But even a gradual wind-down of Fed policies would prompt investors to do more to prepare for inflation and perhaps for a slower appreciation of stock values.

"Policy makers are hinting that the point of maximum liquidity is behind us," B of A told clients. "The era of QE is slowly coming to an end."

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Third, investors seem to be shifting away from high-growth stocks to shares that typically hold up better in a downturn, such as staples and health care. That signals a growing "defensive" sentiment among investors preparing for a downturn, which can itself become self-fulfilling.

Most stock-market analysts still think the 12- to 24-month outlook for stocks is strong, with gains of 5 to 15 percent likely by the end of 2013. The question is what's likely to happen over the next few months. Wal-Mart, as one example, recently said it expects first-quarter earnings to drop slightly, as higher gas prices and the expiration of the payroll tax cuts at the start of 2013 take a bit of extra money out of consumers' pockets. Weaker-than-expected first quarter profits would be one catalyst pushing stock prices lower.

If there is a 5 or 10 percent correction, however, that may be a healthy adjustment that keeps stocks from becoming inflated and prevents a stock bubble that could trigger a bigger crash. In fact, B of A and many other market watchers think any dips over the next few weeks could be a terrific buying opportunity. The economy will get back on track sooner or later, it may just have a few more detours to make before that happens.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.