What a Week: Getting Late

Hopes for an all-time high turn to dread in the space of two days.
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This week ended with hopes of all-time highs turning to fears of inflation, interest rates, a weak dollar, Iran and China. Anxieties bubbled to the surface as U.S. stock and bond markets sold off in the wake of an

FOMC

meeting that provided little guidance on the state of the economy and its outlook on further rate hikes.

There were even mumblings about the end of the American Empire.

Bearish sentiment clearly dominates, and the question is whether the

Dow

will take one last run at its all-time closing high of 11,722, or simply wither from here. That kind of talk is a far cry from last week's musings on how far stocks can rally on the "Goldilocks" economy.

The major stock averages ended the week badly, with the Dow falling 2.1% in the last two sessions to bring its five-day loss to 1.7%. It ended the week at 11,380. Thursday's close, down 141 points, was its largest single-day decline since January. The

S&P 500

fell 2.6% on the week and 2.4% in the last two trading days, closing Friday at 1,291, and the

Nasdaq Composite

fell 4.2% on the week and 3.3% Thursday and Friday, to close at 2,243. The declines were led by commodities and technology stocks.

As the rout worsened, the

CNBC

meter showing how far the Dow was from its March 2000 record vanished from the screen. In Treasuries, the yield curve steepened as the 10-year bond ended the week yielding 5.19% -- a breakout, and a four-year high. It ended last week yielding 5.11%. The dollar, meanwhile, hit an eight-month low against the yen and a one-year low against the euro. Higher-than expected import prices in April didn't help, although the March trade deficit was narrower than expected, at $62 billion.

Volume was higher than usual Friday with 1.85 billion shares traded on the

New York Stock Exchange

. Declining stocks outnumbered advancing stocks by a 4-to-1 margin. On the Nasdaq, volume was 2.32 billion Friday, with decliners outpacing advancing stocks by 3 to 1.

This week's decline "is potentially of major significance," said Peter Eliades, editor of

Stockmarket Cycles

newsletter. Eliades says that since 1900, every time the Fed's discount rate has climbed to 6%, which it did this week, the stock market falls, with an average decline of 38%. The Fed's discount rate has reached 6% only eight times in the past 86 years. Before this week, it most recently hit 6% in May 2000.

The Problem With 6%
The Dow often trips when the Fed's discount rate hits 6%, which it did this week

Source: Peter Eliades, Stockmarket Cycles

But, given the emotional attachment to all-time highs, it wouldn't be surprising if the market found another wind before a prolonged downturn began. One fund manager said he's waiting for the S&P 500 to hit 1285 -- then he becomes a buyer again. "Right now it is dressed up to look ugly," says the manager, who declines to be quoted by name. Investors seem to be "hiding," or waiting for the tipping point, he says, by adding positions in stocks that are safely at low levels. He mentioned "places to hide" such as

Time Warner

(TWX)

and

Microsoft

(MSFT) - Get Report

, whose stocks were modestly up Friday during the selloff.

The peak hasn't happened yet, says Steven Goldman, market strategist at institutional brokerage firm Weeden & Co. "This is a market looking to a 2% to 3.5% pullback," he says. "Stocks should be supported here on modest declines if bonds stop spiking." There is room for an upturn, says Tobias Levkovich, chief U.S. equity strategist at Citigroup, noting that his sentiment index shows a dip down into "panic" territory this week. Panic readings translate into "significant market gains" over the following six months, with 90% historical probability, he says.

Bond yields may not stop spiking, however. The Fed left its options as open as possible this week. The FOMC declined to indicate an end to its tightening cycle, and it reinforced its data-dependency. This put the steering wheel partially in the hands of the markets. Treasury bonds have answered the call. Even before the statement this week, Treasuries were telegraphing higher interest rates based on inflation data that suggest the Fed hasn't gone far enough in its tightening campaign.

The weakness in the dollar persisted throughout the rally in stocks and the Fed meeting this week. Even though the U.S. Treasury decided not to name China a currency manipulator, investors finally displayed some nervousness about foreign central banks recoiling from dollar assets as they embark on their own monetary tightening campaigns. The TICS data out next week will provide more clarity on whether those fears are warranted.

Commodities took center stage Thursday when prices of gold, platinum and copper skyrocketed. Indeed, demand from emerging markets is part of the commodities rally, as evidence mounts that growth in China, India and other emerging market nations is not relenting. It may be dawning on U.S. investors, too, that China revaluing its currency may help the trade deficit, but it won't correct global imbalances or dampen the force of globalization. Manufacturing labor in China would still cost far less than U.S., EU, or Japanese labor, even if China revalued its currency by 100%, says Philip Poole, global head of emerging markets research and chief emerging markets economist at HSBC Bank.

Oddly, the University of Michigan reported the lowest U.S. consumer sentiment index reading in 13 years. This might have moved stocks higher last week, in the hopes that it meant a Fed pause in hiking interest rates. But that was when the all-time high was within reach and hopes for a dovish Fed statement were still in play. With just data between now and the next Fed decision on interest rates, the stakes are even higher and the outlook a bit darker.

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

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