As volatility returns to market, some advisers prepare for a 10% correction

A sudden burst of market volatility has jarred financial advisers out of an otherwise relaxed summer as Thursday's selloff swept away all of the year's gains in stocks for at least one major index. The Dow Jones Industrial Average, which lost 1.88% on Thursday and lingered in mildly negative territory through early afternoon trading in New York on Friday, is on pace to close the week at its lowest level since May 20. As advisers adjusted on Friday to the idea of welcoming back market volatility, there was no consensus as to what might have triggered the abrupt market dip. The index reached a record high in July but Thursday's 317-point decline in the blue chip barometer was its biggest drop since Feb. 3. Gone was the sense of calm — for some, the eerie sense of calm — that had fallen over markets as the Dow slowly and steadily added nearly 2% this year. The widely watched CBOE Volatility Index, an options-based measure of anticipated S&P 500 swings that's called the fear index, leapt 27% to 16.95 on Thursday, its highest reading since April 11. The sell-off raised the prospect that the market is entering what could be a larger correction, which many advisers have new reason to anticipate. “The market has been pretty kind to investors over the last 18 months or so,” said Jeff Layman, partner at BKD Wealth Advisors. “With the heightened complacency on behalf of investors, what could happen when you do have shocks to the system is it could cause more of a correction than it would otherwise” he added. John J. Canally Jr., investment strategist and economist for LPL Financial, said the market was — and remains — overdue for 5% and 10% pullbacks. Prior to Thursday's drop, the Dow had not experienced a drop of more than 1% since May, which was the longest streak of its kind since February 2007. “There's more conspiracy theories about (Thursday) than on the entire series of the X-Files” television show, said Mr. Canally. The cause of the decline has been attributed to everything from the default of Argentina to a set of disappointing earnings reports. “With all of this stuff going on in Ukraine, and Israel, and Africa, I was surprised in didn't happen sooner,” said Theodore J. Feight, adviser at Creative Financial Design. “I think Argentina bonds threw it for a loop, too.” Mr. Canally pointed out that while some economists think the European Union may need a bond-buying stimulus program from its central bank to avoid the prospect of deflation, the U.S. economy remains strong. Hiring by U.S. employers has been ticking up for six consecutive months, the Labor Department said Friday. And the U.S. economy grew 4% in the second quarter, the Bureau of Economic Analysis said Wednesday. “By many other metrics, we're out of the recovery phase an into the expansion phase,” Mr. Canally said. “There's virtually no chance of having a recession in the next couple of years.” Still, a number of advisers are preparing for a stock market correction. SWITCHING TO CASH Paul Schatz, president of Heritage Capital, said he expects a 10% correction. He switched his clients to the highest level of cash he's recommended since 2011. After the correction, he expects the market to return to its highs. “The bull market is old and wrinkly, but it's very much alive,” said Mr. Schatz. “Let the weakness run its course, and then buy.” That sell-off was meaningful not just for stocks, but also high-yield bonds, which often act in tandem with stocks. Mr. Layman cut his clients' allocations to a high-yield bond fund, the Aberdeen Global High Income Fund (JHYIX) — which had been up to 12.5% of his fixed income portfolios — on July 14. The Aberdeen fund is up 5% this year, but it lost half a percent over the last week. High-yield funds generally speaking had a bad week, losing nearly 0.86% by press time Friday. Some advisers see an opportunity in the market turbulence to deepen their relationships with clients. “The opportunity for advisers is always to prepare your clients and shape expectations,” said John F. Merrill, president of Tanglewood Wealth Management. “It's another opportunity for advisers to reassure their clients that this too shall pass.” The reemergence of market swings had been widely foreshadowed by financial advisers, market strategists and even Federal Reserve officials, who have bemoaned the high risk appetite of investors. Despite those cries, U.S. stocks moved on a fairly steady march, without much of a hiccup, and seemed poised to comfortably book their sixth straight year of appreciation, according to some market watchers. — Minda Smiley and Alessandra Malito contributed to this report.