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Bulls Put Faith in Bernanke

Liz Rappaport

The stock market is pricing in reassurance from the Federal Reserve.

After selling off most of the day on a decline in new-home sales and rising oil prices, the major indices staged a comeback, ending the day in the green, save for a small decline in the Dow Jones Industrial Average. It's as if traders looked at the calendar and saw Ben Bernanke on the docket Wednesday and breathed a sigh of relief.

The Fed chairman testifies Wednesday before the Joint Economic Committee. After surprising the markets with last week's move to a more neutral stance regarding future policy decisions, Bernanke is likely be reassuring about the economic outlook. That is, unless he wants investors to think he's worried about a recession.

Legislators will be voicing the concerns of their constituents about the rising defaults and foreclosures stemming from aggressive lending to subprime mortgage borrowers. According to Moody's Investors Service, 60-plus-day delinquencies on home equity loans rose 45.42% in December 2006 -- the largest year-over-year increase since September 1996. In December, 9.81% of those loans were in 60-plus-day delinquency, compared with 6.74% in 2005.

From Bernanke's seat, the answers need to be comforting to stave off a massive overreaction. Truth is, Bernanke's words usually are soothing, and the stock market has come to rely on rallies when he speaks.

"You might actually get to where expectations for a reassuring Fed offer support for the market into Wednesday," says Marc Pado, chief market analyst at Cantor Fitzgerald, noting that Bernanke is very much a believer in the power of expectations. "He believes expectations for inflation cause inflation, and expectations for the economy send the economy in one direction or another," Pado says.

Indeed, expectations for a Fed-rally could be behind traders shrugging off economic headwinds Monday when the Dow ended the day down only 12 points, or 0.1%, to 12,469.07 after dropping 100 points earlier in the trading session. The S&P 500 gained 0.1% to close at 1437.50, and the Nasdaq Composite finished the session up 0.3% to close at 2455.63.

The points of weakness were tied to the concerns of the day. The Dow Jones Transportation Average fell 1.3% on the day as traders digested oil's 1.06% increase.

Index components, such as airline companies Continental Airlines(CAL) and AMR(AMR), and trucking companies Con-Way(CNW) and YRC Worldwide(YRCW), slipped as much as 3.1%.

"The new-home sales data and the oil prices set off a familiar daisy chain of concerns early on," says Art Hogan, chief market analyst at Jefferies & Co.

Analysts had expected a 5.4% increase in new-home sales, but they fell 3.9% in February atop January's 15.8% plunge. February's decline marks the lowest level of new homes sold since 2000, according to Peter Kretzmer, senior economist at Bank of America. Home prices also slid 0.3% year over year, and the supply of new homes increased to an 8.1 month supply, from 7.3 months in January.

To wit, the homebuilders fared poorly Monday. The Philadelphia Homebuilders Index fell 1.1% on the day, as D.R. Horton(DHI), KB Homes(KBH) and Lennar(LEN) each fell 2% or more.

One might think that the dismal new-home sales data would cause the Fed chairman to express more concern about the economy. But a week after moving in a dovish direction, he is clearly not interested in succumbing to legislative pressure to cut interest rates. He is still expressly concerned about inflation. So Bernanke is likely to reassure lawmakers and the country that the subprime meltdown has not spilled over into the broad economy. This way, he maintains his just-left-of-a-tightening-bias stance.

If he suggests anything to the contrary, traders would surely assume the Fed is acknowledging some kind of disaster. There is a slim chance that Bernanke will come out extra-hawkish to let the markets know they interpreted last week's FOMC statement incorrectly. But, given Monday's words from Chicago Federal Reserve President Michael Moskow, that is unlikely.

In a speech in Beijing, Moscow said the housing market "is in the process of stabilizing, and that by the second half of the year, housing will start to pick up again." On the question of spillover from the subprime segment of the market, he said, "There's no evidence of that happening so far. I think it's a very low-probability scenario."

Also, Roger Cole, the Fed's director of banking supervision, reassured lawmakers in testimony last week that he sees no spillover from subprime to standard mortgages.

"We expect a similar tone from Mr. Bernanke, which may impinge on the markets' view that Fed easing is only a couple of meetings away," writes Joseph Lavorgna, chief economist at Deutsche Bank.

Impinge away. It's all about managing expectations.