David Joy: Stocks zigzag as Fed keeps investors guessing

After suffering through two straight weeks of losses, stocks staged a strong rebound on Thursday and Friday to squeeze out a gain of 0.8% last week. Confusion over the Fed’s intentions and mixed economic data had driven the S&P 500 lower by 3.6% from its closing high of 1669 on May 21, to its recent closing low of 1609 on June 5. The move higher on Thursday and Friday earned back a lot of that decline with a combined gain of 2.1%. If the recent pullback has run its course, which certainly remains to be seen, it will have looked quite similar to the two previous pullbacks we have experienced so far this year. The first came between February 19 and 25, in response to the release of minutes from the Fed’s January meeting. It resulted in a 2.8% decline. The second came between April 11 and 18, and came after some unexpectedly weak economic data and the release of more Fed minutes. It resulted in a decline of 3.2%.  Beyond the similar extent of these three declines, another common element is the unmistakable influence of the Fed in both triggering them and resolving them. Each was triggered to various extents by rising fear of the Fed pulling back on quantitative easing sooner than expected. And each concluded as those fears subsided, either in response to public statements by the Fed, or in response to the release of economic data that will have a strong bearing on the Fed’s thinking.

In the latest episode, the Fed has said or done nothing overt to help calm the waters. In fact, it has succeeded in keeping investors guessing, and increasingly on edge, about just what it is going to do, and when. But if the Fed’s actions are data dependent, then Friday’s jobs report answered the question for it, and to the street’s satisfaction. The creation of 175,000 non-farm jobs in May, along with a rise in the unemployment rate to 7.6%, was enough to convince equity investors that the economy remains healthy, but not strong enough to convince the Fed it can start to throttle back. Any decision to do so from either the June or July FOMC meetings would now have to be made for non-economic reasons, and that seems unlikely.

There is also an additional element to the current episode. Last week’s reversal began at midday on Thursday, a day before the jobs report. It began just after the S&P 500 had broken through the 1600 level, albeit fractionally. But there it found its footing, between its 50-day moving average of 1605, and its 65-day moving average at 1593. The emergence of buying demand at that level provided a shot in the arm for a market that had been drifting. The enthusiasm fed into the jobs report, and stocks closed on Friday at their high for the week, after a two-day rally of 2.1%. They now reside just 1.5% below their previous closing high.

The jobs report wasn’t the only economic release of importance last week. Most notably, the manufacturing sector, which had been decelerating since March, shrank in May for the first time since November. That weakness was echoed in the loss of 8,000 manufacturing jobs in the June employment report, blamed on the sequester and lack of corporate investment, as well as weakness overseas. Factory orders were also lighter than expected, although the service sector was a little stronger. On balance, it was another week of mixed reports, and enough to keep the Fed on the job.

While stocks were falling between May 22 and June 5, bond yields were rising. The yield on the ten-year Treasury note climbed from 1.93% to 2.09%. However on Friday, the rally in stocks pressured Treasuries further, and the ten-year ended the week at a yield of 2.17%, its highest since April of last year. Lower-quality bonds had been pressured even harder during the selloff. Since May 8, when the option-adjusted spread between the BofA Merrill Lynch High Yield Master II index and the ten-year Treasury note bottomed at 423 basis points, the yield on the Treasury note had climbed forty basis points, while the high-yield index had risen 66 basis points. According to Lipper, high-yield bond funds had to absorb a record $3.2 billion in redemptions for the week ended June 5. But, it seems that the weakness in high yield is a little out-of-synch with both the equity and Treasury markets. If they are right, then maybe high yield is due for a rally. In fact, the yield-to-maturity of the High Yield Master II index fell ten basis points on Friday alongside the rally in stocks, as its spread to Treasuries narrowed nineteen basis points.

Next week we await another round of influential economic reports. May retail sales are expected to rebound from a sluggish April. The same is true for industrial production, which expects to see an increase after a decline in April. The preliminary Reuters/University of Michigan June consumer sentiment survey is expected to be flat after a strong May reading. The Fed meets again in less than two weeks, on June 18-19. Expect a healthy debate, but no action. But, that meeting will include a press conference by the chairman. It will be an opportunity to clarify the Fed’s current thinking, or at least attempt to do so.

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The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The Thomson Reuters/University of Michigan Consumer Sentiment survey is a survey of consumer confidence which uses telephone questionnaires to gather information on consumer expectations regarding the overall economy.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

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