Over the past two months, we’ve warned that the S&P 500 could pull back by 5 percent to 10 percent this spring. Recent market action suggests that this correction may have started. If our forecast pans out, the second quarter could give us an opportunity to buy high-quality names at favorable prices.

Here’s our four-part strategy for the next few quarters:

• Buy yield at the right price: Focus on master limited partnerships, royalty trusts and integrated oil companies that trade below our buy targets.
• Book profits on overextended names: If you’re still sitting on sizable gains in Portfolio holdings that trade above our buy targets, take advantage of these lofty valuations to raise some capital.
• Buy undervalued growth stories: Oil-field services stocks will benefit over the long term from the end of easy oil, or the increasing expense of incremental production. Current stock prices don’t reflect this upside.
• Hedge your bets: Last summer, our short bet on First Solar (NSDQ: FSLR) made money while the broader market tumbled. Our current bet against North American natural gas producers could offset some damage if stocks pull back in the third quarter.

This updated strategy is primarily a function of my outlook for the broader market and energy commodities.

The Global Economy

Whereas market participants were overly bearish about the global economy’s growth prospects last summer, investor sentiment has now grown far too optimistic about the strengthening US economy.

Last summer’s swoon stemmed in part from temporary headwinds such as supply-chain disruptions caused by Japan’s devastating Sendai earthquake and a spike in oil prices in early 2011. This year, many investors are overlooking the impact of an unseasonably warm winter on economic activity. That’s not to suggest that we expect the US to lapse into recession in 2012; rather, US gross domestic product (GDP) will continue to grow at a lackluster rate of 2 percent to 3 percent.

Consider recent trends in the Citigroup US Economic Surprise Index, which is calculated on a three-month basis and increases when a data point beats the Bloomberg consensus estimate and declines when a data point falls short of expectations. The data points themselves are weighted by their importance to economic models and historical power to move the stock market.

Source: Bloomberg

The economy’s 2010 summer swoon touched off a 17 percent correction in the S&P 500 between April and July. A number of factors contributed to this breakdown: the first stage in the EU sovereign-debt crisis that resulted in a bailout for Greece; the end of the Federal Reserve’s first round of quantitative easing; a major oil spill in the US Gulf of Mexico and concerns that the US government would allow the tax cuts implemented by George W. Bush to expire as planned on Dec. 31, 2010.

After stocks rallied from late summer 2010 into the spring 2011, the US economy found itself mired in another soft patch. The proximate causes of the 2011 summer swoon included: supply-chain disruptions stemming from the earthquake that hit Japan in March 2011; surging oil prices after the outbreak of civil war in Libya; an intensification of the EU sovereign debt crisis; the end of the Fed’s second round of quantitative easing; and Standard & Poor’s downgrade of the US government’s credit rating.

In keeping with the pattern established in the past two years, US economic growth accelerated in early fall. A number of downside catalysts could set the stage for history to repeat itself: elevated oil prices; the end of the Fed’s efforts to lower long-term interest rates by buying long-term bonds; uncertainty surrounding the upcoming presidential election and subsequent tax policy; and another flare-up in the ongoing EU sovereign-debt debacle

Trends in the Citigroup US Economic Surprise Index are eerily reminiscent of the summer swoons of 2010 and 2011. The index surged late last year because analysts’ estimates had grown overly bearish; today, the consensus expectations have overshot economic realities, opening the door for disappointment.

Seasonal distortions stemming from the winter that never was are one cause for concern. Most economic data points are seasonally adjusted based on historical data to average out predictable fluctuations and isolate emerging trends.

For example, retailers hire people ahead of the holiday season even in bad economies; that employment rises ahead of the holiday season reveals little about underlying trends in the jobs market.

Construction activity and home purchases typically decline in winter months and pick up again during the spring thaw. But last winter was the fourth-warmest in recorded US history. Accordingly, construction activity got under way earlier than usual and home sales that normally would occur in May or June took place on an equally balmy day in February and March. In this situation, the standard seasonal adjustments will skew results.

Consider this little-watched data series from the Bureau of Labor Statistics’ monthly Employment Situation report.

Source: Bureau of Labor Statistics

This graph tracks the number of employees in the US who missed work because of bad weather–a data point that isn’t seasonally adjusted. Usually, there’s a spike in weather-related absences during the winter, but the 2011-12 winter brought the fewest missed workdays since the 2000-01 winter. 

This trend suggests that the government’s normal seasonal adjustments to jobs data–including the widely watched nonfarm payrolls number–overestimated the usual weather-related decline in employment. Larger-than-expected gains in employment in late 2011 and early 2012 have driven the rally in the stock market, but there’s a good chance some of the increase stemmed excessive seasonal adjustments.

The March employment number released on April 6, 2012, indicated that the US created 120,000 jobs, falling significantly short of a consensus estimate that called for 205,000 new positions. The latest figure also marks a major deceleration in job creation, from 275,000 in January and 240,000 in February 2012. In fact, the March nonfarm payrolls number was the worst since October of last year.

Seasonal adjustments to employment data tend to be less pronounced in March than in January and February because of improving weather. That the March data disappointed could be the first sign that normal seasonal adjustments in an abnormal winter artificially inflated results.

Investors should also consider another wonky seasonal adjustment: the lingering impact of the economy hitting a wall after Lehman Brothers declared bankruptcy. Factoring this dramatic meltdown into seasonal adjustments could contribute to the mini-boom and mini-bust pattern that’s characterized economic growth in the past two years. 

Although this hypothesis is difficult to prove, the theory’s empirical appeal is difficult to deny: Depression-like data from fall and winter 2008-09 makes for easy comparisons, while the economy’s subsequent recovery in summer 2009 provides a tougher hurdle. Over each of the past two years, the US economy has experienced a summertime soft patch and wintertime acceleration. These unusual seasonal swings could be a statistical legacy of the Great Recession.

Nevertheless, the US economy remains on reasonably strong footing and shouldn’t slip into recession in the near term. Rather, the biggest risk resides in incoming US economic data that falls short of analysts’ elevated expectations.

Europe

Whereas US economic recovery should continue to plod along, the EU has likely slipped into recession. The Eurozone Purchasing Managers Index (PMI) measures economic activity in the region based on surveys of major manufacturing firms. PMI readings greater than 50 indicate expansion; data points that are less than 50 indicate contraction.

Source: Bloomberg

Although we don’t have decades of historical data for the Eurozone PMI, recent trends are a cause for concern.

A brief uptick in business sentiment earlier appears to be an aberration stemming from improving credit conditions for Italy, Spain and other fiscally weak member states in the wake of the European Central Bank’s (ECB) Long-term Refinancing Operations (LTRO). This program allowed EU banks to borrow money from the ECB at 1 percent for terms of three years; some of those funds were reinvested in bonds issued by the Club Med nations of Greece, Italy, Portugal and Spain.

But the Eurozone PMI has headed south once again. Although the index hasn’t tumbled to the depressed levels of 2008 and early 2009, recent readings of between 45 and 47 suggest that the EU has fallen into at least a mild recession.

The prospect of a turnaround is dimmed by inevitable austerity measures. Italy recently raised its 2013 deficit target, indicating that lackluster economic growth has inhibited the government’s efforts to balance the budget. Reduced government spending in healthier nations such as France and Germany will also weigh on economic activity.

After investors fretted about Italy’s fiscal health last summer, Spain has emerged this year as the Club Med destination of choice for skittish market watchers to focus their attention. Whereas Italy’s debt-to-GDP ratio of 120 percent is much higher than Spain’s 68 percent, Italy also boasts lower levels of household debt and a sounder banking system. Spain’s banks, on the other hand, have outsized exposure to soured real estate and construction loans.

Although Italy and Spain’s governments enjoy borrowing costs that are well below their 2011 highs, trends in the market for credit default swaps (CDS)–which track the cost of insuring Italian and Spanish government debt against default over a five-year term–paint a foreboding picture.

Source: Bloomberg

The cost of five-year credit default swaps on Italian and Spanish government debt had declined sharply since late last year. But Spain’s CDS now regained their 2011 high. In fact, the 10-year Spanish CDS briefly hit a new record high on Friday, April 13. These developments suggest that the market is far more worried about Spain’s fiscal health.

This concern is warranted: Spain’s central government has struggled to rein in spending at the regional level, while the nation’s unemployment rate has approached 26 percent–the highest in the eurozone.

Although the EU’s ongoing sovereign-debt crisis receded into the background for several months, a permanent resolution remains elusive. This latest flare-up could be a considerable headwind for global equity markets.

Developments in France are also cause for concern. Planned budgetary cuts will be complicated by a presidential election that will likely narrow the field to two candidates–Socialist challenger Francois Hollande and the incumbent Nicolas Sarkozy–rather than produce an outright winner. Sarkozy is deeply unpopular and could lose a run-off election that would occur in early May.

Hollande has proposed several measures that would prove unpopular with investors: raising the top income tax rate to 75 percent, reducing the retirement age to 60 from 62 and boosting government employment by as much as 60,000 positions. Hollande has stated that his proposed policies would balance the budget by 2017–a year later than the current Sarkozy government has projected under its austerity regime. Bottom line: A Hollande victory would likely put pressure on the French government’s borrowing costs and call into question its ability to control the deficit.

Although the worst of the EU sovereign-debt crisis appears to have passed, investors shouldn’t expect much economic growth from the EU over the next year or two.

China

Shifting our focus to the East, we continue to expect China’s central government to engineer a soft landing for the economy. China’s official PMI for the manufacturing sector climbed to 53.1 in March, a welcome recovery from its November 2011 low of 49.

Policymakers last year hiked interest rates and bank reserve requirements in an effort to quell inflation; trends in PMI indicate that these measures successfully cooled China’s overheating economy.

Toward the end of 2011, lower inflation prompted China’s government to reduce banks’ reserve requirements, a move that appears to have spurred lending. In fact, surge in loans is the strongest since the government enacted stimulus measures in late 2008 and early 2009.

Source: Bloomberg

This uptick in lending should shore up economic growth. We expect China’s GDP growth rate to bottom out in the first quarter and pick up slightly into the second half.

The Stock Market

My outlook for the stock market is grounded in my economic outlook. With the US economy facing a number of headwinds, the likelihood of the S&P 500 suffering another summer swoon appears elevated. Rising concern about the EU sovereign-debt crisis won’t help matters while lumpy economic growth in China could also weigh on investor sentiment.

The S&P 500 trades roughly 25 percent above its October 2011 low and isn’t far from its four-year high. Meanwhile, at the end of March, the tech-heavy Nasdaq reached its highest levels since the 2000 tech bubble. In light of this historic rally, investors appear to anticipate more positive economic news than they did six months ago–leaving considerable room for disappointment if data points fail to meet lofty expectations.

Based on these headwinds, the S&P 500 and most major stock markets could pull back at least 5 percent to 10 percent during the seasonally weak second and third quarters. However, I don’t foresee an outright collapse akin to the one that occurred summer.

This outlook underpins my strategy of taking profits in Portfolio holdings–Core Laboratories (NYSE: CLB) is a prime example–that trade significantly above our buy targets.

Investors who take some profits off the table right now will be in an excellent position to take advantage of attractive valuations during the correction. You don’t need to liquidate entire positions; consider selling one-third to one-half your position in names that trade above our buy targets.

As energy stocks lagged the broader market in the first quarter, many of our picks could be less exposed to a correction than financials and other high-flying groups.

I’m also adding the ProShares Short S&P 500 (NYSE: SH) to the Hedges Portfolio and my Best Buys List. This exchange-traded fund (ETF) tracks the inverse daily performance of the S&P 500; for example, if the S&P 500 drops 1 percent, then ProShares Short S&P 500 would rally roughly 1 percent.

ProShares Short S&P 500 and other ETFs that track the daily performance of a given index will produce returns that diverge from the benchmark’s overall return over a given period. For example, the S&P 500 rallied 12.6 percent in the first quarter of 2012, but ProShares Short S&P 500 declined by 11.5 percent. And in the third quarter of 2011, the S&P 500 fell about 13.8 percent, while ProShares Short S&P 500 gained 12.7 percent.

The tracking error for ProShares UltraShort S&P 500 (NYSE: SDS)–an ETF designed to track double the inverse of the S&P 500–is much greater. For example, in the third quarter of last year, the ProShares UltraShort S&P 500 returned 23.5 percent rather than the 27.6 percent one might have expected after the S&P 500 gave up 13.8 percent.

ProShares Short S&P 500 tracks the inverse performance of the S&P 500 relatively closely and is a convenient option for investors who’d rather not short individual stocks. I only intend to hold this hedge for a quarter or two at most to cushion the blow of a potential correction. ProShares Short S&P 500 ETF rates a buy under 37.50 in the Hedges Portfolio and my Best Buys List.