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Stock Pendulum Swings Back to 'Down'

A data-focused market reacts negatively to jobless claims and a Fed president's comments.
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Given that the

Federal Reserve

has made it clear that further rate hikes will depend on data, the stock market has been showing more reaction to economic reports lately.

That's creating a lot of uncertainty and volatility, depending on the mood -- and the report -- of the moment.

News that January core consumer prices were in line with expectations Wednesday helped relieve inflation anxiety, and stocks rallied. Thursday morning, a bigger-than-expected drop in jobless claims stoked inflation fears anew, and stocks dropped.

Later in the day, comments by Philadelphia Fed President Anthony Santomero were construed again as confirming that the Fed will soon stop raising interest rates. "We have been moving monetary policy toward neutrality for some time, and our policy appears to be close to neutral now," Santomero said.


S&P 500

and the

Nasdaq Composite

returned to positive territory after the remarks, while the

Dow Jones Industrial Average

recovered some ground after a 80-point drop.

But stocks reversed again to finish lower, with blue chips giving up much of their gains from the previous session. The Dow dropped 67.95 points, or 0.6%, to 11,069. The S&P fell 0.4% to 1287 and the Nasdaq lost 0.2% to 2279. News that one billion songs have been downloaded from



iTunes online store lifted the stock 0.6% but failed to inspire gains elsewhere in the tech world.

According to Tony Crescenzi, interest rate strategist at Miller Tabak and a

contributor, Santomero's suggestion that rates were near neutral -- where they neither spur nor restrain growth -- were misinterpreted to mean the Fed was nearly done with raising rates. But nothing is currently preventing the Fed from pushing rates to a level where they become restrictive, Crescenzi noted.

In this context, it's hard to say how the market will react to Friday's report on January durable goods orders. The report is expected to show a 0.3% drop last month after a 1.8% gain in December. That's mostly due a big drop in aircraft orders at



, according to Lehman Brothers. But ex-aircraft and non-defense capital goods orders, a good measure of business investment, durable goods are expected to show a solid 1% increase, marking the third straight month of gains.

Many economists have been banking on business spending to prop up the economy should consumers falter this year. Wall Street may therefore not like the report very much, as it might give more ammunition for the Fed to raise rates further.

According to Miller Tabak, the market is now pricing in 100% odds that the Fed will lift rates at least two more times over the next three rate-setting meetings, taking its key rate to 5% by mid-June. And odds that the rate will rise to 5.25% in August were priced in for the first time Thursday. The market sees a 10% chance of such a rate.

The idea that the Fed would soon stop raising rates helped the stock market rise from the lows it reached back in October of last year. The logic was that the certainty of rising interest rates had cast doubt about future earnings growth, thereby putting a cap on stock prices. Removing the certainty of higher rates should, according to the prevailing logic, allow stocks to move higher.

But now that every piece of economic data has to be viewed as either friendly or unfriendly for the end-of-rate-hikes scenario, the market is facing its own contradictions.

Only evidence that the economy is really slowing will take the Fed completely out of the picture, but that's a bearish scenario for profits. Evidence that the economy remains strong, possibly stoking inflation, will keep the Fed in the game for longer than currently expected.

The latter would be a much more bullish scenario for growth and profits, according to the long-held view of Jim Paulsen, chief investment officer of Wells Capital Management. He'll remain bullish on the economy and profits, as long as the Fed keeps raising rates.

Paulsen's main point is that the central bank has been playing catch up to economic growth, after injecting an unprecedented amount of liquidity in global financial markets.

"The contemporary Fed tightening cycle has been different from its onset," Paulsen wrote, in his latest note to clients. "It was initiated from the lowest yield level since the Great Depression."

Indeed, the yield of a 10-year Treasury bond was barely above 3% in 2003, when the Fed began ratcheting up its key rate from a 40-year low of 1%. Now that the fed funds rate has returned to a "neutral" level, according to Fed officials, the yield of a 10-year bond is just at 4.5%, roughly the same level as at the end of 2003. Before that, such low long bond yields hadn't been seen since the 1960s.

"There is little sign Fed tightening is having much impact," Paulsen wrote. U.S. monetary tightening cycles are usually accompanied by a drying up of global liquidity, affecting emerging markets and commodity prices around the globe.

But after a mini meltdown over the past few weeks, commodities prices have more recently been on the rise again.

The only thing that might contradict Paulsen's view about the Fed's lack of biting power, is that the housing market has been slowing since last summer although recent results and guidance from homebuilders

Toll Brothers







Pulte Homes


have frustrated the real estate bears.

And mortgage rates, which use the yield of the 10-year Treasury bond as a benchmark, also remain historically low.

Freddie Mac


reported the average 30-year mortgage dipped to 6.26% from 6.28% last week.

Paulsen believes it would take a spike in long bond yields for housing to come down with a bang. In the meantime, the Fed has room to lift its key rate to at least 6% as the economy -- and profits -- continue to expand, he suggests.

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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