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Investors may feel justified in thinking the second quarter has been little more than a crystallisation of the fears that dogged the first. From the anxious speculation of early 2008, investors have moved from a position of fearing a slowdown to the recognition that the prospects for growth are now being seriously tested.

A disparate array of data has served only to reinforce the gloomy outlook. From leading housebuilder Persimmon cutting back on its programme of activity as first-time buyers take flight, to curtailed economic forecasts, weak consumer spending and rights issues from the banks, the market is facing the reality of a serious squeeze.

Yet for all the concern, it is not unrealistic that investors will start contemplating a recovery, not least as the likelihood of an economic downturn has been priced incredibly quickly into the markets. At its peak, the FTSE All-Share fell 15.5 per cent within the first quarter, closing down 10.9 per cent on the year to date. At the time of writing, the index has already retrenched some of that jittery ground, gaining 5.9 per cent as investors recognise the value that has been opened up as a result of the market’s heady falls at the start of the year.

Recovery in the current cycle will be anything but conventional. A more typical strategy would see investors plough money into depressed areas such as housebuilders and retailers, yet it is clear these sectors are still vulnerable and could have further and longer to fall before they are due a re-rating.

This is because the market’s recovery may itself be unlike those we have witnessed in the past. In previous downturns, central monetary policy has focused on relaxing rates, producing a consumer-led recovery. However, the Bank of England is, for now, taking a more conservative stance, locked in a stagflationary threat of protracted upward pricing pressure, set against weak domestic growth. The spiralling prices of commodities and raw materials are further squeezing the disposable income of buyers, making consumer spending power an unlikely exit out of the current situation.

Looking at the fundamentals, the likelihood of these pressures easing in the short term is unlikely. This particular boom has flourished in an era of cheap and available credit, and thus the recovery of financial companies is itself essential for any such rate cuts to impact the consumer directly. The market has successfully anticipated the actions from the Bank and their probable effect on easing the situation.

An uplift in the market will therefore require much more radical action than the quarter-point cuts we have seen to date. As such, investors should consider the prospect of an export-led recovery, from companies that are well positioned to benefit from the weakness of sterling.

It is essential investors do not take a sector-led approach to their investments. Until recent months, the market has witnessed incredibly benign conditions and strong rises have been seen across share prices. What is now emerging is a much more divergent landscape. This is not the start of a typical bear market, but a period of greater volatility accompanied by some strong individual performances. Future success will be highly dependent on identifying opportunities on a much more stock-specific basis. A highly-diversified portfolio is essential to help mitigate risk, both in terms of the number of stocks held within the portfolio and their business type and geographic exposure.

With this caveat in mind, investors may wish to look at individual buying opportunities within obviously depressed sectors that have been hit hard in recent months – housebuilders, retailers and financials. However, they should do so with caution.

For example, areas such as retail and housebuilders remain heavily dependent on the financial health of the consumer, which is currently being pushed to the hilt. While high street favourites such as Marks & Spencer and Blacks and Kingfisher have demonstrated the value of store refurbishments and will continue to commit capital to these programmes, they can only go so far – particularly while buyers remain stretched.

Housebuilders are unfortunate in that they are directly affected by the lending crisis as well as the external pricing pressures currently facing buyers. In spite of impressive land banks and p/e ratios of as little as 3.1, these conditions need to change before any uplift can take effect. They are further exposed by their highly geared, volume-driven models, which may mean prices have further to fall unless corporate activity emerges. Similar gearing among property shares could leave investors much more exposed than to the outright fall in property prices across the country. Their gearing could mean an 8 per cent fall in property in real-terms results and anything up to a 20 per cent fall in the shares themselves.

Potentially, the most interesting recovery play is to come from financials directly. A company such as HSBC has little recovery potential, in that it has been fairly insulated by the geographic diversification of its business model and the belief among the investing community that it is best positioned to withstand further macroeconomic instability. The rest of the sector has certainly been dramatic, with the emergence of the major rights issue at HBOS a particular cause for concern, diluting value for existing shareholders. Yet, over the slightly longer term and on a stock-by-stock basis, value is emerging.

The banking sector is not for the fainthearted, not least as any further gloom in the macroeconomy will continue to trigger volatility. However, first-quarter results remain promising and the increase in dividend yields from some of the major banks suggests value is beginning to appear. Dividend pay outs will also provide a buffer for investors as they look for the share prices themselves to recover in the medium term. Some positive news flow and signs of improved interbank lending conditions is the necessary stimulus the sector now needs.

Insurers are also providing attractive yields, while having the advantage of not being directly exposed to the lending crisis. Value has been created as a result of the poor weather and flooding of summer 2007, resulting in an increase in premiums. Should the sector bear witness to some consolidation, insurers could prove an interesting area of the market to peruse. Those with additional diversification, either by geography or business unit – such as Prudential’s exposure to the East – are particularly attractive in order to best mitigate risk.

The market’s broader recovery is much more interesting for the investor than typical recovery plays. Yet reading the market in the current climate is difficult, with a number of specific issues weighing on sentiment.

This includes the impact of the changes to the capital gains tax regime, which has received little attention but should not be underestimated. While the new 18 per cent rate gives investors much greater ability to free up existing investments and will boost liquidity, this may translate in the coming months to a downward pressure on prices as investors look to capitalise their gains and escape the market’s current volatility. Further pressure on share prices has also been witnessed among small caps, in a defensive flight to perceived quality. In this climate, investors drawn to recovery should focus on exactly the types of stock that have been dragged down by sentiment, but where the fundamentals are still sound.

Some oil exploration and production stocks could be seen as falling into this category. While commodities have enjoyed an impressive run to date, there has nonetheless been a defensive retreat especially from some of the smaller shares, which is opening up more value for investors. With the price of oil soaring and potentially remaining above the three-figure mark per barrel, the current valuation of assets often looks incredibly conservative. For example, companies such as Northern Petroleum calculate assets at only about $70 a barrel. With reserves dwindling for major players, corporate activity should also not be overlooked, which would further value the potential of these assets at a premium. In spite of its good run, the fundamentals suggest a level of “recovery” could come from those companies which have suffered disproportionately as a result of jittery sentiment.

An investment strategy that looks to specifically locate bottomed-out opportunities can only work for those investors prepared to back their holdings for a longer time period. For those who prefer to defensively invest and stick close to the index, the prospect of active recovery investing is unappealing. Instead, they will look more to the market’s own recovery and a similar, more modest upturn in performance. While this steadily defensive course is fine for the lower-risk investor, a sudden switch into cautious stocks should be avoided. Some classically defensive safe havens are now looking expensive. They could come at a hefty price tag if the market should fall further, while any benefit of recovery from other areas has been sacrificed.

A careful, bottom-up strategy is the only way to chart a course through the much more complex market that is unfolding. For those who deploy a more rigorous approach, buying opportunities are out there. Timing and a commitment to look across the market as a whole is the key to success.

Paul Mumford is a senior fund manager at Cavendish Asset Management