The Coming Week: Fed Watch Far From Over

Even those being pulled into the bullish camp are concerned about what another rally might bring.
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Break out the Trapper Keepers. The market is going back to school.

The

Federal Open Market Committee's

decision this week to raise interest rates by 25 basis points and maintain its neutral bias surprised virtually no one. It also did little to quell fears that the year's second rate hike won't be its last. As loathsome as the notion may sound to those tired of this summer's waiting game, the coming week promises to look a lot like the previous ones: The market is back on Fed watch.

We've seen this movie before. On June 30, when interest rates rose 25 basis points, many interpreted a shift in the Fed's policy directive to a neutral from a tightening bias as a signal that the dirty business was past. Then the July employment report came out smoking, and talk shifted from whether the Fed would raise rates at all to whether a 50-basis-point move was in the offing.

The lesson is pretty clear. If next week's data come out too hot, the Fed will tighten further. If not, it won't. Simple as that.

"Who knows whether the Fed's going to raise rates?" moaned Peter Boockvar, equity strategist at

Miller Tabak Hirsch

. "No one's smart enough to know the data."

That may be. But there's a sizable contingent that believes that Y2K liquidity issues will stay Fed chief

Alan Greenspan's

hand. The tension between that camp and those more inclined to follow the economic data will likely define the rough contours of next week's action.

As for the numbers themselves, next week will usher in the first August data, including the

Chicago Purchasing Managers' Index

on Tuesday and the

National Association of Purchasing Managers

index on Wednesday. The week culminates on Friday with last month's bugbear, the employment report.

"All the numbers in between now and next Friday will be talked about in the context of the employment situation, which is so important to Greenspan and such a key driver in the bond market," said Gail Dudack, equity market strategist at

Warburg Dillon Read

.

"If the numbers are benign, the bonds will rally," said Boockvar. That would be good news for the bond-watching stock market. If the long bond yield can stabilize below 6%, Dudack said, stocks should react positively.

Despite the last two days of light-volume selling, the market still seems to be on strong technical footing. "We're just seeing normal profit-taking from the rally earlier this week," said Dick Dickson, technical analyst at

Scott & Stringfellow

. "If we get it cleared up next week, we'll be in a good position going forward."

"Liquidity is clearly positive," Dickson elaborated. "Momentum is clearly positive. Don't step in front of a speeding bus."

The image of that speeding bus (we've all seen that movie, too) will likely get a lot of play next week in the wake of Alan Greenspan's speech today before a

Kansas City Fed

symposium in Jackson Hole, Wyo. Postulating a link between the protracted rise in stock valuations and consumer spending, Greenspan said the Fed's "analytic tools are going to have to increasingly focus on changes in asset values and resulting balance sheet variations."

The notion of the Fed paying closer attention to the stock market, coupled with the market's technical strength, has some worried. It's got Hugh Johnson, chief investment officer at

First Albany

, more than a little spooked by the prospect of another rally in the coming week. "By my math, the market is overvalued," Johnson explained. "And when you move to a rising inflation and interest-rate environment, P/E ratios should come down. It would be healthy if

the Dow would come down to the 10,500 or 11,000 level. Otherwise we run into the risk that the market will be characterized as speculative by the Fed.

"If we stay on a roll, it could invite the Fed to ... I still don't believe it'll do it on speculation alone, but it could be a factor," he said. Still, Johnson isn't bearish by any means: "I wouldn't start raising cash yet."

Neither would Dickson. "I'm bearish by nature," the strategist said. "I'd like to be bearish. I'm worried about valuations, how high this market's gotten. But I can't work up a good bear case now. I guess I'm being dragged kicking and screaming over to the bull camp."

He'll probably find a reluctant Johnson there as well.