Don't sweat the selloff, part 2

NEW YORK (CNNMoney.com) -- The two-day selloff that took the Dow industrials down more than 200 points could be a harbinger of a volatile summer on Wall Street - but don't let it make you think the stock market is done hitting record highs this year.

According to a recent Standard & Poor's study, the broad index is likely to see more records over the next few months and years - if the history of the last 10 bull markets is any guide.

The S&P 500 (Charts) finally snapped its seven-year-old record high from March 2000 last week. And although it was with decidedly less fanfare than when the Dow Jones industrial average first started setting records last fall, the implications are just as relevant for the market.

Standard & Poor's chief market strategist Sam Stovall took a look at how the S&P 500 performed after hitting a record high, examining the previous 10 bull markets dating back to the 1940s. (See chart for details).

His research found that despite expectations to the contrary, it was not all downhill right after the S&P 500 hit its new high.

Stovall found that the S&P 500 typically had a difficult first month after hitting a record, but ended up seeing better-than-expected returns in the next three to six months. (See charts).

So far, the S&P 500 seems to be following the first part of the trend. After hitting a record high Monday for the third time out of four sessions, the index - along with the rest of the market - has been sliding for the last two session.

The declines came as investors worried that economic growth may be accelerating too quickly after hitting a five-year low in the first quarter. That could cause a renewed pickup in inflation, and force the Federal Reserve to start raising interest rates again, even as the housing market slump drags on. Higher rates tend to slow growth and crimp earnings - clear negatives for stocks.

But on another level, the selloff this week has been a fairly typical response to the market's powerful rally this year, analysts said. It's that rally that lifted the S&P 500 to its new record in the first place.

As a result, the slide is probably a short-term phenomenon, said Dan Genter, president and CEO at RNC Genter Capital Management.

Over the last two sessions, the major gauges have each dipped no more than 1.5 percent - a minimal decline, Genter said, considering the Dow had been up nearly 10 percent year-to-date before the selloff. He said the selling may not be over, and could take the major averages down 4 to 6 percent, including the recent pullback, but that would be reasonable given the speed of the advance.

"On a near-term basis, we are going to see a lot of volatility," Genter said, as investors take some profits and wait for the second-quarter earnings reports to start pouring in.

Once earnings season's in full swing, investors should have a better sense of how profits and stock prices will be impacted by economic growth and inflation. In turn, this should help clarify whether stocks will remain as fairly valued as they are now, he said.

Also, by early July, the next wave of economic news will have been released and the Fed will have held another policy meeting, all of which should give stock investors more direction.

Longer term, the prospects look better for the rally. Stovall's research showed that each of the last 10 bull markets didn't hit a so-called "top" until more than three years after the S&P 500 first hit its record, on average.

That's not to say the current bull market won't end up topping out for another three years - it is getting quite old from an historical standpoint - but it does help temper worries that on a technical level, the recent high was the last for some time.

At a little over 4-1/2, the current bull is about a month older than the historic average, by Standard & Poor's calculations. The bull run has been in place since October 2002, after a three-year bear market following the late-1990s tech boom.

The age of the current bull market is one of many reasons investors have been concerned that stocks could be due for a bigger pullback, beyond the two-day decline, despite the positive factors that continue to buoy the market.

Those include better-than-expected earnings, the ongoing flow of money into the market from private equity and other deal makers, corporate stock buyback plans, and solid economic growth.

Until very recently, a sense that the economy is strong but not too strong could have been added to that list. Yet in the first few sessions of June, that perspective seems to have changed. But analysts say enough positive remain that investors are likely to use any weakness in June as an opportunity to get back in at lower levels.

The S&P 500 finally recouping its losses from the three-year bear market could strengthen that resolve on the part of many investors.

On a psychological level, the fact that the S&P 500 has made a new high is important in that "pretty much anyone who invested in the S&P 500 at any point in time is now sitting on a profit," said Mark Arbeter, chief technical strategist at Standard and Poor's. "That is, assuming the person sat through the entire period."

Granted, the profit would be minimal for an investor who bought an index fund after the previous closing high in March 2000, but nonetheless, the sense that stocks have recovered from the bear market is underlined by the S&P 500's recovery.

But if the stock market has really recovered from the bear market, what explains the lagging Nasdaq composite (Charts)?

The Dow Jones industrial average closed at a record high Monday for the 27th time this year and the 49th time since October 2006, according to Dow Jones.

After first breaking its record on May 30, the S&P 500 closed at records for the next three sessions through Monday. Even the Russell 2000 (Charts) small-cap index ended Monday's session at a new record.

Meanwhile, prior to the recent selloff, the tech-fueled Nasdaq composite was still 48 percent below its all-time closing high of 5,048.62 set March 10, 2000, making it clear that not all areas of the market have participated fully in the comeback.

Still, S&P's Arbeter said the scope of the recovery has been broad, even if it has been less tech-driven than the late 1990s rally. He noted that all different asset classes have participated, and the advance has been driven by investors both here and abroad.

His biggest concern on a technical level is that if the market rises too quickly over the next six months, too many individual investors would be tempted to jump back in, and as any contrarian can tell you, that's usually the beginning of the end.

On one hand, AMG mutual fund data suggest individuals are starting to put more money back into stock mutual funds. On the other hand, the bullishness of Wall Street pros is still ahead of that of individual investors, Arbeter said, and historically that's been important.

Besides, selloffs like the one this week should help delay the "everybody-is-already-in" risk factor that Arbeter referred to.