Traders returned Tuesday from a long holiday weekend unwilling to do anything but take profits from the strong gains of the past few weeks. Mixed economic data were no help, with a rise in consumer confidence in May overshadowed by further evidence of a slowdown in manufacturing.

The most exciting action in the market was in the bond pits, with the 10-year Treasury yield falling below 4% following the PMI data.

Also worth noting was Stephen Roach, the chief economist at Morgan Stanley, who finally turned bullish on bonds. He expects that a China-led slowdown will temper both global growth and inflationary pressures next year.

The

Dow Jones Industrial Average

finished down 75.07 points, or 0.71%, at 10,467.48. The blue-chip index was pressured by

Alcoa

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, which received a subpoena linked to an investigation of the aluminum fluoride sector.

The

S&P 500

lost 7.27 points, or 0.61%, to 1191.51. Among others,

Exxon Mobil

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and

Chevron

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succumbed to profit-taking even after an analyst upgraded the shares and crude oil futures rose 12 cents to $51.97 per barrel on Nymex.

Energy shares, which have led the recent rally, fell less than others. The

Nasdaq Composite

fell 7.51 points, or 0.36%, to 2068.22. Continuing the trend of the past few weeks, Wall Street brokerages are still pumping up almost every area of the tech sector like there's no tomorrow. On Tuesday, Piper Jaffray raised its price target on

Google

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to $300 from $275.

Breadth was positive, with advancing issues outpacing declining ones 9 to 7 on the

NYSE

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and 15 to 14 on the Nasdaq. But trading volumes remained very light -- a trademark of the market's recent upside. Only 1 billion shares traded on the Big Board, and 1.2 billion issues changed hands on the Nasdaq.

The story for stocks was simple: profit-taking on the last day of the month. After the market's dismal performance in the first four months of the year, traders actually had room to sell on the last trading day in May. During the month, the Nasdaq gained 7.6% and the S&P 500 added 3.0%.

Supporting the May bounce was the proverbial "wall of worry" erected by fears of stagflation in March and April. Strong employment and retail sales together with tame inflation then allowed bulls to climb over that wall. But how strong does the wall remain?

Most Wall Street economists have turned the page on what they dubbed a temporary, oil-induced "soft patch." But the debate over where the economy is headed is not over. The so-called "Goldilocks" scenario of not-too-hot, not too-cold economic growth, which is used to support the case for further gains in stock prices this year, is far from a given.

The bond market, for one, keeps discounting inflation at levels that would suggest economic growth will slow radically. On Tuesday, bonds surged on news that the Chicago purchasing managers index fell sharply in May. The price of the benchmark note surged 22/32 while its yield ended at 3.99%. The data reinforced expectations that the

Fed

will end its rate-tightening schedule sooner rather than later.

Wednesday's release of the national Institute for Supply Management index is now the key. Some market observers noted that a reading below 50 has always led the Fed to stop tightening rates in the past.

Adding to the rally in bonds was the surge of the dollar against the euro. The European currency fell to a seven-month low after French voters rejected the proposal for a European Union constitution.

Side factors supporting bond prices -- most recently it was flight-to-safety amid credit jitters and rumors of hedge fund trouble -- have been exhausted, one after the other. After the most recent safe-haven flows subsided, bond prices have not returned to their previous level -- on the contrary, they continued to rise.

Even Morgan Stanley's Roach, who has long been bearish on bonds, has now joined the bulls, saying "he wouldn't be surprised" to see the yield of the benchmark 10-year test 3.5% next year.

Roach believes that the Chinese economy -- after six years of impressive growth -- is about to slow due to China's effort to curb its own property bubble and external pressures to curb its exports.

Even a modest cooling would drag Asian economies down and impact world growth. At the same time, China accounts for 8% of the world's consumption of crude oil, 20% of aluminum consumption, and 30%-35% of coal, iron and other commodities. A slowdown would intensify existing pressures on commodity prices. "That could have an important impact on tempering the inflationary expectations embedded in bond markets," Roach wrote to clients.

Foreign central banks and other foreign lenders also will likely continue to buy U.S. debt -- and fund the huge U.S. current account deficit -- because interest rates here remain attractive relative to interest rates around the world.

A major risk, however, remains the recent trend toward trade protectionism. Both Europe and the U.S. have heavily pressured China to curb the flood of its cheap exports. Instead of letting the yuan float, China itself imposed tariffs on some of its exports before backtracking on the issue Monday.

According to Roach, a protectionist backlash could very well turn into a trade war. That would put Chinese financing of the U.S. current account deficit (China is the second-largest holder of U.S. Treasuries behind Japan) at severe risk. "The bond market could then do a quick about face and come under severe selling pressure," Roach writes.

That would, of course, be bad news for the housing market, which has continued to fuel a consumption spending binge over the past few years. For the time being, at least, the drop in gasoline prices and the April rebound in employment have revived consumer confidence, according to the Conference Board's latest survey for May.

And as the yield of the benchmark bond, used to set fixed mortgage rates, dipped below 4%, homebuilding stocks once again advanced. The Philadelphia housing sector index rose 0.36%, supported by the likes of

Toll Brothers

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, which rose 1.68%.

To view Gregg Greenberg's video take on today's market, click here

.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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