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Dow Sets Record: More Highs to Come, or a Pullback?

The Dow Jones Industrial Average is at its highest level ever, while the benchmark S&P 500 sits just 1.6% below its all-time peak.

We talked to big market players, Jeffrey Kleintop, chief market strategist at LPL Financial ($373 billion in assets under management), and Hayes Miller, head of asset allocation in North America at Baring Asset Management, ($48 billion in assets) to get the answers to questions investors want to hear, as the four-year bull run approaches its March 9 birthday.

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Are the markets off to the races? Should you get in now if you still have cash on the sidelines? Or is it time for a pullback, or even a correction?

Kleintop says: “The Dow stands 115% higher than it did four years ago. However, this time the Dow no longer holds AIG (NYSE:AIG), Citigroup (NYSE:C) and GM (NYSE:GM) -- among others -- as it did at the prior peak on October 9, 2007.”

He says yesterday’s trading “is another example of how the stock market continues to trace the pattern of the past two years around the latest Dow milestone.”

You can see that trading action in this chart here:

Kleintop adds: “We see the stock market stuck with some ups and downs around Dow 14,000 for much of the year, trapped between the positives and the negatives, as last year was stuck around 13,000 from early February until year-end and in 2011 the same thing occurred around 12,000.” He adds: “Overall, I see a balance of good and bad news keeping the market in balance around the recent milestone.”

Kleintop’s positives: -- U.S. housing strength -- Don't Fight the Fed -- Rebounding business spending -- Low stock market valuations -- Energy renaissance -- Strong cash balances -- Pending bonds to stocks rotation -- Consumer & business balance sheets

Negatives: -- European weaknesses -- Coming end of QE -- Sequester/government shutdown/debt ceiling -- High gas prices -- Weak global GDP -- Sluggish profit growth -- Investor risk aversion -- Government balance sheet

What should investors do? “Be nimble,” Kleintop advises. “In this kind of up-and-down market environment we think investors should seek to benefit from volatility.”

How? Here’s what Kleintop advises:

*Buy the Dips - Buying the dips in fundamentally improving areas such as Homebuilders and Industrials makes sense. *Sell the Rips – Selling/Trimming those that have had big run ups, but have some vulnerability like Transports. *Seek Yield - Focusing on the yield of an investment rather than solely on price appreciation can enhance total returns. Bank loans and even alternative vehicles like MLPs offer a yield advantage over investments that are solely price-driven during periods of high volatility.

And what about the Federal Reserve’s stimulus?

“The Fed has been a key support for the stock market over the past four years that the Dow has rallied,” Kleintop says. “As the pace of economic growth continues to stabilize around 2%, the Fed may find the rising cost of the bond buying program, and its increasingly limited benefits to growth, may mean they need to stop or slow the program later this year. Each time over the past four years the Fed stopped or debated ending their bond buying program it has contributed to a stock market pullback that ended as the Fed resumed purchases.” Fair warning.

Barings’ Miller says: “We find the market is fair valued versus expensive in 2007, but we’re a little bit worried that at the current levels, the markets are already discounting the good news that’s been anticipated for the rest of this year. Meaning, we’re not going to get any revaluations higher based on good economic news. The market has already digested the good news coming this year.”

What about solid corporate earnings growth?

“Obviously, earnings numbers continue to be reasonably good. But the good economic news will offset the Federal Reserve’s reaction to good economic news, because good economic news means the Fed unwinds its stimulus and that’s bad for the markets. (Societe Generale) now forecasts the 10-year Treasury at 3.4% handle, that’s a lot higher than where it is now.”

Miller added: “We’re living off of a stimulus. Profit margins are already at peak levels. Margins in 2011 and 2012 were off the charts in the US, we see profit margins scaling back down from that. Earnings per share for the year for the MSCI US equity index, analysts wrongfully see around 9% EPS growth for 2013. But that number is traditionally biased upwards. Go to most investment houses, talk through the numbers, they say just 3%. A lot of fear is that we’ll see the top line erode a bit, especially because of a stronger US dollar versus the euro, yen and sterling, so export numbers won’t be stronger. So we’ll see top-line erosion, and profit margins that can maybe hold at 2012 levels. Biggest issue to watch is capital expenditures, whether companies reinvest in the US economy by buying equipment or expanding.”

What do you think?

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