Your guide to this summer's market

6:00 PM guide, market, summers No Comments

| By Jim Jubak

The trend in US stocks appears downward because of expectations of what the Fed will do. But the consensus view is volatile. Here’s how to navigate the turmoil.

Think of the current market this way: It's a puzzle where the solution shifts depending on whether you take a long-, medium- or short-term view, and where the importance investors afford to the long-, medium- and short-term views shifts from hour to hour and day to day.

Then add in that you have to solve that puzzle with significantly different time horizons depending on which of the three drivers of global financial markets -- the United States, Japan and China -- is gathering attention at the moment.

Together, this makes the market very difficult to read, very volatile and rather scary.

Here’s my guide to what’s going on, what to pay attention to and what to ignore in the next few weeks.

Consider the May 31 market action as a good example of what we can expect in June and probably into July.

That morning, a medium-term view held the court. A strong report on Midwest manufacturing activity led traders and investors to focus on the possibility that the U.S. Federal Reserve would start reducing its $85 billion a month in purchases of Treasurys and mortgage-backed assets sooner rather than later and perhaps as early as this summer or in September. That led bond prices to retreat, while the yield on a 10-year Treasury climbed 0.15 percentage points, to 2.21%. One month ago, the yield on the 10-year Treasury was just 1.65%.

That afternoon, perspective shifted back to the short-term. Bond prices had fallen so far so fast on the day and yields on the 10-year bond were now above the 2.08% yield on the Standard & Poor’s 500 Index ($INX) that short-term traders were willing to bet that bond prices would stage a modest rally.

Jim Jubak

Their willingness to take that bet increased as the weekend approached. It’s typical for traders to take profits and square positions before the weekend. Taking the end of a trade predicated on rising bond prices and falling yields had a good risk/reward ratio in the short term. And traders on that end of the trade did make a good profit, as bond prices rose and yields fell back to 2.13% at the market close.

And what about stock prices? They moved in exactly the opposite direction to bonds, rallying in the morning and then falling sharply in the afternoon, largely, I think, in reaction to the move in bonds rather than to any significant news for equities themselves.

In the background for all this sits the long-term view. The consensus there is that the Federal Reserve will have to taper off (the medium-term view) and then end (the long-term view) its program of buying Treasurys and mortgage-backed assets. At best, the end to the Fed’s buying program will push interest rates higher. In an even longer long-term view, interest rates will rise as the Fed sells Treasurys to reduce the size of its balance sheet.

A lot of this consensus view is speculative. No one knows if the Fed will actually sell Treasurys -- Chairman Ben Bernanke has hinted that the Fed will simply hold them to maturity and reduce its balance sheet very gradually. No one even knows if the Fed will start to taper off its buying program in the summer or fall. The Fed has said that its actions will depend on the data, and no one yet knows what the economic data will look like in, say, September.

But 1) this consensus view seems logical and 2) this consensus view is the consensus, and that gives it influence over the U.S. financial markets, even if it ultimately turns out to be wrong.

Until we get data that say the Fed will stay on the sidelines or get growth numbers so strong that investors are willing to buy stocks no matter what the Federal Reserve may be planning, or see some statement from the Fed that recasts its policy, I think the long-term consensus will provide a bearish cast to the short- and medium-term views of the market.

But remember that this relatively long-term negative view doesn’t have the stage to itself. Just as on May 31, when the bond market was able to rally because the short-term view said there were profits to be made by reversing the morning's slide, so too could a sufficient drop in U.S. stocks lead to a calculation that, in the short-term, reversing any drop would be profitable to traders who had gone long.

In other words, if U.S. stocks drop far enough, say 5% to 10% (the S&P 500 was down 2.3% from its May 21 high at the close on May 31), then I think we’ll see short-term buying pick up no matter the pessimistic long-term view.

I know this is complicated, so let me try to boil it down.

I think the trend in the U.S. financial markets is downward right now, because of the long-term consensus view that the Fed will begin tapering off its monthly purchases of Treasurys and mortgage-backed assets by September or October -- and perhaps even earlier. We could get a temporary bounce out of a disappointing jobs report on Friday -- the consensus among economists is for a weak 165,000 net new jobs -- but I think it will be hard for any disappointment to shake the consensus. I think the downward trend could easily produce another bad month for Treasurys like the 1.8% drop in the Bank of America Merrill Lynch index in May.