NEW YORK ( TheStreet) -- The Federal Reserve has made it clear that it wishes to see improved labor markets and economic growth, but the intricate details seem to be rattling investors.
Fed Chairman Ben Bernanke said on Wednesday that if the economy improves, monetary easing could be toned down. That is the equivalent of weaning a child from his or her bottle, because a big part of the rally has been the central bank's stimulus.
With Bernanke's mention of a reduction of bond purchases, equities got spooked, even though Bernanke's language -- as always is the case with the Fed -- was vague. The market's volatility on Wednesday and Thursday was due to such vague language and to a weaker China, but in the days ahead, volatility should subside.
The pair below is of S&P Equal Weight ETF (RSP) over SPDR S&P 500 (SPY). It measures market breadth, or the amount of participation in the rally. When the pair rises, it means that a majority of the index is moving higher, which is bullish.
There was a breakout higher in early May, and the recent downturn has provided a much-needed pullback to the support line. It does not look as if Bernanke's statements have derailed the current trend higher, but have merely provided some relief to an overbought market.The next pair is of SPDR MidCap Trust Series (MDY) over S&P 100 Index Fund (OEF). This pair looks at the internal strength of the rally similar to the chart above. Strong rallies tend to be led by smaller-cap stocks versus larger-cap defensive companies. The price action below shows that the smallest 400 companies in the S&P 500 have led the index higher throughout this past rally, and have just recently hit resistance.
The pullback has come in the face of speculation that the market is overbought and is due for correction. The variability of economic data has kept markets questioning the sustainability of the rally, and now with the uncertainty surrounding stimulus, markets have found a reason to pull back. As long as the pullback stays within the downward channel pattern, there looks to be room for a break higher. Volatility has been a threat to markets lately, as evidenced by Thursday's wide price swings in the equities market. Generally, with volatility, funds rotate into more defensive sectors. The chart below acts as a form of volatility measure. It compares the Dow Jones Select Dividend Index Fund (DVY) over S&P Equal Weight ETF. The relative strength of large-cap, defensive stocks moves inversely to a risky economy, and correlates strongly to volatility. The pair below is approaching yearly lows that have been reached only one other time since early in 2012. The pair has yet to show a convicted move either higher or lower, which means that for now, markets hang in the balance. If the pair spikes higher, look for volatility to return with vigor in the markets. If it breaks lower, look for equities to push through their all-time highs.
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