Investors eye correction, defensive rotation

In coming months, stock investors may find the best form of offense is defensive. The steep gains in equity markets over the past several months -- the S&P 500 is up 25.8% since September 1 - have sparked concerns stocks are over-extended.

The correction many expected has not yet materialized.

Investors are rotating money around equity sectors rather than moving out, a trend that may dominate for several months.

Stocks could remain supported by the Federal Reserve's USD 600 million bond-buying program that continues through June.

Investors may already be preparing for when that program wind-downs by buying dividend-payers, especially telecoms, seen as defensive and undervalued.

"While before all you had to do to double your money was just be in stocks, you'll have to be more perceptive to outperform from here," said David Joy, chief market strategist at Columbia Management in Boston, which oversees USD 347 billion.

According to Credit Suisse data, correlation for S&P stocks to the S&P -- a measure of how components move in relation to the broad index -- has dropped sharply, meaning the securities no longer move in lock-step, creating a so-called stock-picker's market.

In a January 20 note to clients, the firm said the current one-month correlation coefficient was 0.15, compared with a 0.51 level in early December. Credit Suisse said there was potential for that correlation to fall further, placing more of a value on outperformance of individual names. A correlation of 1.0 implies a constant relationship; minus-1.0 is a perfect inverse relationship.

"I'm expecting a rotational correction, where groups will get hit, perhaps by as much as 10%, but not at the same time as others, meaning the market average won't go down as much," said Marc Pado, US market strategist at Cantor Fitzgerald & Co in San Francisco.

Many hear the call of Telecom

A common theme amongst analysts who see the market's voracious gains coming to an end is to lean to high-dividend stocks. As interest rates rise, bonds become a more attractive investment, and a guaranteed return from dividends offsets the impetus to switch out of equities.

Telecommunication stocks stand to outperform, many strategists say. The group has underperformed the broader market, but its average dividend yield of 5.92% is the highest among S&P sectors. The S&P's average yield is 2.25%, which is up from the prior year.

So far in 2011, the telecom sector is down 2.4% while the S&P is up 5%.

Cliff Remily, a money manager at Santa Fe-based Thornburg Investment Management, which oversees USD 70 billion, said one of his biggest weights was for telecom companies, which he described as "among the cheapest stocks in the world."

"If you're looking for income, the most logical place is these secure dividend-paying stocks," he said.

Dow components AT&T Inc and Verizon Communications Inc rank among the top 20 S&P 500 components in terms of dividend yields and are underpriced according to Thomson Reuters StarMine estimates.

StarMine's intrinsic value model values a company's stock based on its most likely growth trajectory over the next decade or more (with steady growth assumed after that).

AT&T would need to climb 58.4% to reach its intrinsic value, based on its Monday closing price, while Verizon would need to gain 24.8%.

CenturyLink Inc, another telecom company and the third-highest dividend payer in the S&P, would need to advance 41% to reach its intrinsic value.

"Telecom is underappreciated and is inexpensive on both an absolute and relative basis," Remily said.

Some attribute the market's gains over the past several months to the Fed's quantitative easing program, which flooded markets with cheap money. Fund managers looking for value have been frustrated as expensive stocks have continued to rise, while value stocks have struggled to appreciate.

Now, many ask what the fallout will be after the Fed stops pumping liquidity into the markets.

"When the music of QE2 stops, there won't be anything to prop up lower-quality names that have posted such exceptional returns," said Matt McCormick, portfolio manager at Bahl & Gaynor Inc in Cincinnati, Ohio, which manages USD 3.2 billion.

"That's why we're looking for high-quality dividend stocks from here. Those will give you protection and are the way to play both the short- and long-term market."