It's Called a Correction There's nothing unusual about a pullback in a bull market--and it creates bargains if you know how to spot them
By Michael Sivy

(MONEY Magazine) – Pessimism is rampant. Despite a string of good statistics--on growth, productivity, housing and unemployment--an increasing number of investors think the economy is falling apart and the bull market is just about over. In fact, there's no reason to believe either of those things. Barring catastrophic terrorism or some other severe shock, blue-chip share prices could advance for another couple of years.

Why then are investors so negative, when the economic bellwethers are pointing in the right direction? In part, the Bush administration's failures in Iraq have cast a pall over everything else. One poll shows disapproval of current economic policies rising to 56%, a gain of seven points since December, even though hundreds of thousands of jobs have been created. In addition, investors fear that higher oil prices, inflation and rising interest rates will stall the economy and end the bull market.

The recovery continues

The economy's strengths should become more evident later this year. Nonetheless, there's nothing unusual about a new bull market suffering a correction. In the nine bull markets between 1950 and 1999, corrections occurred after 16 months, on average, and the Dow industrials typically lost 16% over four months (see the chart below). The current correction certainly follows the pattern. It began 17 months into the recovery, and the Dow has fallen nearly 10% over four months.

Terms such as bull and bear market, correction and rally are often used loosely, but they have specific meanings. True bear markets, with declines of at least 20%, occur either because the economy goes into recession or because stock prices get wildly overvalued. Bear markets are followed by bull markets, in which share prices can more than double.

Those moves are called primary trends. But bear markets often include at least one rally of at least 10%. And in each bull market, there's normally at least one correction, defined as a decline of 10% or more. Rallies and corrections are called secondary trends.

It's worth trying to figure out whether a trend is primary or secondary because secondary trends can tempt you to act prematurely. You don't want to jump into the market with both feet during a bear market rally and then get dragged down when the decline resumes. And you don't want to bail out of a major bull market simply because of a normal correction.

Of course, no one can identify such trends with anything approaching certainty. That's why it makes sense to run a well-balanced, conservative portfolio at all times. But you can lean a little to one side or the other--selling stocks that look overpriced in the midst of a boom, or hunting for bargains in a correction.

Among the stock groups that are well positioned right now, high-yield stocks are appealing as defensive choices. In addition, major integrated oil companies such as EXXONMOBIL (XOM) and CONOCOPHILLIPS (COP) are sound picks for an era of high oil prices. Right now, however, many stocks in a variety of industries look cheap, simply because the correction has pulled down the broad market.

Cheap is cheap

One of the most telling indicators of such potential bargains is cash flow. If a hypothetical acquirer could buy a company with borrowed money and then pay off the loan with the cash the acquired business generates, the stock is cheap in an absolute sense. Here are three stocks that meet that test.

ANADARKO PETROLEUM (APC) has more than three-quarters of its reserves in North America, a big attraction if investors become concerned about the security of oil supplies. At $54 a share, the stock trades at 11 times earnings and yields 1%. That price values the company's reserves so cheaply that Anadarko can now get a better earnings bump by repurchasing its own stock than by drilling. For the same reason, Anadarko is regarded as a possible takeover target.

J.P. MORGAN CHASE (JPM) looks to be the cheapest of the international commercial banking giants. Profit margins may be squeezed temporarily by rising interest rates, but such a diverse financial services firm can prosper in a variety of rate environments. J.P. Morgan's earnings jumped 38% in the first quarter and are expected to grow about 10% annually over the next five years. At $36, the stock is trading at only 11 times 2004 earnings and yields a healthy 3.8%.

UNION PACIFIC (UNP) is the largest U.S. railroad company, and its business pretty much tracks overall economic activity. Recently, however, the railroad has been unable to keep up with demand because it doesn't have enough crews or equipment. In response, Union Pacific is hiring and buying locomotives. In the longer term, growth is projected to average around 10% a year. At $56 a share, Union Pacific trades at 14 times earnings and yields 2.1%.

Michael Sivy can be reached at SIVY_ON_STOCKS@MONEYMAIL.COM.