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NEW YORK (Reuters) - With the U.S. stock market nearing record highs, portfolio managers are preparing for a pullback.
Some are shorting the broad Standard & Poor's 500 index and putting money into Japanese equities instead. Others are selling stocks that haven't rallied yet, based on the theory that the momentum for these stocks must be broken. And others are buying companies like Coach Inc, whose recent quarterly earnings results came in below analyst expectations, as long-term value plays.
It's an about-face for many fund managers, who have spent the last few years explaining their bullishness to clients who were skeptical about the stock market. Yet with the tide in sentiment appearing to shift, some fund managers say that now is the time to become contrarian. Early evidence of that shift in sentiment includes the $12.7 billion in new dollars invested in stock funds in January, the largest four-week flow since 1996, and a nearly two-year high in the American Association of Individual Investors weekly bullishness survey.
"We think we're heading for a correction that could well wipe out the gains we've had this year. We're in a stage of euphoria and it's not a healthy thing in the end," said Barry James, who oversees five portfolios as the head of James Advantage Funds, which is based in Alpha, Ohio.
Here are some of the strategies of fund managers who are skeptical of the broad market rally.
The Dow Jones industrial average closed at 13,986.52 Wednesday, just 1.3 percent below its nominal high of 14,164 that it reached in October, 2007. The S&P 500, meanwhile, closed at 1,512.12, or 3.4 percent below the high it closed at in 2007.
Both indexes have gained 6 percent or more since the start of 2013, thanks to a combination of seasonal inflows into stocks, a corporate earnings season in which 69 percent of companies have beaten expectations and signs that Europe's debt problems are improving.
That quick start to the year is turning some money managers defensive.
"The market has run far and fast, which by definition means that you're vulnerable in the short term," said Seth Reicher, president of San Francisco-based Snyder Capital Management.
Reicher isn't entirely abandoning the stock market, which he considers a better alternative than low-yielding bonds. But he is staying away from sectors he considers "extraordinarily expensive" such as real estate investment trusts and utility companies. Instead, he is focusing on companies with very high cash flows but that do not pay a dividend, which he believes make them more likely to grow earnings.
He's been adding to his position in Clean Harbors Inc., which has a dominant position in the North American market for hazardous waste disposal, and is expected to increase its free cash flow by 21.4 percent in 2013. The company's shares are down 3.6 percent for the year through Wednesday, and trade at a price-to-earnings ratio of 26.7.
Brian Singer, a portfolio manager of the $66.2 million William Blair Macro Allocation Fund, recently began shorting the broad U.S. market by buying out of the money puts that expire in mid-April and increased his positions in Japanese equities and Spanish and Italian stocks.
His reasoning: continued political brinkmanship in Washington over scheduled spending cuts scheduled to take effect March 1 will lead to another high-stakes standoff. If the cuts, dubbed the "sequester," go forward as scheduled, federal spending would be cut by about $85 billion for one year, and would fall by $1.2 trillion through 2022.
Other portfolio managers are searching for overlooked value plays.
Marian Kessler, a portfolio manager of the $169 million Becker Value Equity fund, said that the market's rally is making it "tougher to find new ideas" that have the potential to outperform. Lately, she's been putting more money into retail stocks.
She recently began buying Coach after shares fell nearly 16 percent after the company missed analyst expectations and said it would move further away from its baseline handbag market and into the shoes and clothing segments. But Kessler, who believes that the company's share price drops were due in part to selling by growth fund managers, is attracted to the company's strong cash flow and yield of 2.4 percent, she said.
James, the Ohio fund manager, has been selling some of his past winners like Family Dollar and Dollar Tree, as well as stocks that have underperformed in the recent rally like Southwest Gas Corp., which is up 3.9 percent over the last three months, compared with a 5.7 percent jump in the S&P 500. That underperformance suggests that the stock's gains will be limited by poor momentum, he said.
Instead, he's been buying companies like Ford Motor Corp. and furniture maker Steelcase Inc. that will benefit from the improving jobs market. Yet he's also expecting the market to peak soon, so he is increasing his level of cash, too.
"A market peak is next to impossible to call," he said. "We're taking steps to lower our equity exposure but we'll ride this rally as long as we can."
Reporting By David Randall; Editing by Jennifer Merritt and Kenneth Barry