The summer doldrums are here for the stock market. Last week, the market correction continued with the Dow Jones Industrial Average sliding lower for a fifth straight week … a rare occurrence.

“What rare occurrence?” you may be thinking, especially given the 2008–2009 sell-off, but it’s true. In fact, you would have to go back to mid-2004 — seven years ago — to find the last time the Dow closed lower for five weeks in a row.

Nevertheless, despite how nerve-racking this period may be for stock investors, the reality is, in three of the past five weeks, the Dow posted only a small fractional decline. While the Dow was down 2.3 percent last week, the blue chip index is still up 5 percent year-to-date.¹

In other words, this isn’t a violent sell-off in stocks … but this downward bias is raising investor concerns that it could turn into more than just an orderly summer swoon.

Summer Struggle for Stocks?

Let’s look at historical patterns to gauge what might lie ahead.

First of all, price action like this isn’t terribly surprising at this time of year. Historic seasonality suggests a volatile trading pattern with a downward bias during the summer months. Since 1950, the Dow has tended to struggle through the middle of the calendar year, with up and down whipsaw moves common.²

Historically, September has been the worst performing month for stocks as measured by monthly returns of the Dow since 1950. But the second worst month has been … you guessed it: June, which has posted a decline of nearly -0.5 percent on average.³

The unsettling issue is June still has three weeks to go. However, on a more positive note, even though stocks tend to struggle through the summer, July has often more than reversed June’s decline … posting average gains of more than 1 percent historically.

Naturally, there are more than just seasonal factors weighing on the stock market right now.

Weak Economic Data Contributes to Investor Concerns

As our Chief Market Strategist Bob Pavlik points out, investors remain concerned about a number of issues in the news today …

The never-ending housing market weakness …

Budget and debt ceiling concerns here in the US …

Fears over the unresolved Eurozone debt crisis, including the possibility of a default or restructuring by Greece … 

Concerns over what will happen to the US economy after QE2 comes to an end this month.

The latest batch of economic reports pointing to a slowdown in global growth, particularly in manufacturing.

We covered these topics in detail in recent issues of the Banyan Market Letter. But what really grabbed investors’ attention last week was the dismal May employment report — and for good reason.

The US economy created just 54,000 nonfarm jobs last month, a sharp slowdown from the 220,000 average pace of hiring during the three months prior. As a result, the unemployment rate ticked up slightly to 9.1 percent.⁴

Although certainly a disappointment for the markets, the slow, uneven pace of job growth isn’t really a surprise. We’ve been dealing with a sub-par job recovery ever since the recession ended.

The graph above shows the path of job losses and hiring during the current cycle (black line) compared to previous recession recovery scenarios for nonfarm payrolls. As you can see, in past recoveries the economy was able to work its way back to peak employment levels more quickly than it has this time around.⁵

The so-called jobless recovery following the 2001 recession is the most similar pattern to what we are now experiencing in terms of duration. In that case, it took nearly four years to get back to full employment.

Of course the magnitude of job losses during this most recent recession was much greater than in 2001. Therefore, we believe it could take even longer to put people back to work this time around.

Considering the recent string of economic disappointments, plus the steady (but not that severe) pullback in markets, investors are beginning to wonder if this slowdown is only temporary — or a sign of worse to come.

We Expect This Soft Patch to Pass in Time

While we can’t be 100 percent certain, our take is that the current slowdown in the economy is a temporary soft patch.

First, let’s recognize that many investor concerns are already well known today and have been priced into the market — hence contributing to the pullback in prices.

High energy prices … ongoing disruptions caused by the earthquake and tsunami in Japan … plus other natural disasters here at home ... the debt ceiling debate in Congress … the approaching end of QE2 are all priced into the stock market.

Second, be prepared for headline risk to continue over the next month or so. Remember, the summer has historically been a time of choppy market conditions, and we could have more volatility and weakness as the issues above are resolved.

By mid-July, we expect the market to begin stabilizing, and it may even be ready for a sustainable rally. In the meantime, we remain conservatively optimistic in our market outlook.

We have raised cash, trimmed some positions in overweight sectors, and are now waiting to opportunistically take advantage of this uncertainty to buy great companies at attractive prices.

Sentiment indicators appear to have moved to a negative extreme in recent weeks, which can be taken as a positive sign. Whenever market sentiment gets too bearish, it’s often considered a contrarian signal that stocks may be poised to rally, at least in the short term.

Take the CBOE Put/Call ratio, for example (see graph below). Recently the ratio of trading volume in bearish put options compared to bullish call options spiked to the highest level since September 2010. When buyers of put options get this aggressively bearish, it often adds to the probability of a short-term bounce in stocks.⁶

Make a List and Check It Twice

We’re not saying you should jump into the market with both feet right now, but it’s a great time to start making a list of stocks you really want to own.

First, make a wish list of stocks to keep a close eye on and write down the price you’re willing to pay. Then, be patient.

When the time comes and these stocks reach your target price, you will have taken the emotion out of the equation, and you’ll be ready to act.

Here’s a case in point from Banyan’s Chief Investment Officer Michael Blackmon. “I expect the technology and financial sectors to be among the leaders coming out of this correction,” he says.

Technology stocks are selling at the most attractive levels in more than a decade, according to several valuation measures.⁷

“We’re long overdue for a technology replacement cycle,” explains Michael. Corporations are flush with cash, and businesses are set to boost computer and software spending, according to industry data. Tech sector profit growth is expected to surge 24 percent this year, well ahead of the projected 17 percent earnings growth for the S&P 500 Index. Plus, technology stocks trade at a discounted price-earnings multiple compared to the overall index.⁸

One of the leading stocks on our wish list right now is technology giant Qualcomm (NYSE: QCOM), a leading maker of chips for smart phones. Not long ago, the stock traded close to $60 per share, but QCOM has drifted lower in recent weeks as the market corrected.

We believe QCOM is worth about $70 per share, and it’s on our Banyan Buy List. Downside risk in the stock, in our opinion, is limited to about $50 based on our fundamental assessment. If we see the share price at or close to that level, we’re ready to make a move.

Another way to potentially take advantage of the confusion and uncertainty in markets is to consider writing covered call options on stocks you don’t want to sell at current market prices.

A volatile market like this can be an advantageous environment for writing near-term covered calls to bring in extra income for your portfolio, while reducing the cost basis on your stock positions. In choppy markets, the time premium you earn from selling call options can also potentially enhance your total return.

Bottom line: While we acknowledge the downside risks posed by the string of weak data and growing macroeconomic uncertainties, we also see a strong trend in corporate profits continuing, which tells us job growth and other economic data should eventually bounce back. This should help keep the expansion on track, leading to more upside ahead for the stocks on our Buy List.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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Banyan Partners and the advisory accounts that we manage may have option positions and/or long or short positions in the securities mentioned in this report and may purchase or sell such securities without notice. The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to any company, industry or sector mentioned in this report. The strategies mentioned may not be suitable for all investors. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

Options involve risk and are not suitable for all investors. Commissions and advisory fees will affect the outcome of the transactions. Investors are encouraged to read the “Characteristics and Risks of Standardized Options” for additional information and risk disclosures regarding options.

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¹ Bloomberg market data, 6/7/11
² Chart of the day, 6/3/11
³ Ibid.
⁴ Bureau of Labor Statistics, 6/3/11
⁵ New York Times: Comparing Recessions and Recoveries, 6/3/11
⁶ Bloomberg market data; 6/7/11
⁷ Bloomberg: Technology Stocks Cheapest Since 1998, 6/6/11
⁸ Ibid.