Santoli: Fed puts stocks' delicate balance at risk

Published Wed, May 18 20163:28 PM EDTUpdated Thu, May 19 20163:35 PM EDT

It's not the waxing prospect of a Federal Reserve rate increase that has the stock market on edge Wednesday . Not directly, anyway. After all, investors should be encouraged by the conditions that are prompting Fed officials to keep two, or even three, rate hikes in play for this year: The job market's tightening, wage growth is quickening, deflation fears are waning and global financial footing is more stable. What really accounts for the fitfulness of equities in recent days is the way those gently revived rate-hike expectations sharpen the focus on the ticklish balance of factors that have allowed stocks to hang within a few percent of their all-time highs for months now. This equilibrium rests on a cooled-off dollar, a strong recovery in oil prices, a sturdy high-yield credit market and — to an important but lesser degree — the idea that the Fed is happy to stay on hold with its tightening campaign through Labor Day. Source: FactSet All of these factors — combined with investors positioned far too bearishly near the midwinter market lows — have supported stocks even in the absence of a well-telegraphed "profits recession." Dramatic strength in typical "defensive" dividend stocks (utilities, consumer staples and telecommunications) has bolstered equity indexes in the absence of broad profit growth. A drought in junk-bond issuance and heavy demand for higher-yielding paper have fortified the high-yield debt market. This is truly the beacon for stocks, capturing the combination of liquidity, corporate financial conditions and risk appetites that bear on equity values. Yet the S & P 500 has alternated up and down sessions the past eight trading days as the market tries to decipher whether this stable backdrop is changing. Read More Long, sideways market periods lead to big gains Strategas Research fixed income strategist Tom Tzitzouris lays out the delicacy of this arrangement: "If all goes well, and inflation inches higher, with wages remaining a step behind price gains, and the Fed on hold indefinitely and the dollar flopping around current levels, then HY spreads should compress" even more than they already have. He suggests this friendly formula could keep working for a while, but would not easily survive an encounter with resumed erosion in corporate profit margins or a sharply hawkish Fed message. The credit research folks at Bank of America Merrill Lynch believe this flutter of concern about a June or July bump in short-term rates is likely to pass without imparting much pain — as happened in April when hawkish Fed speak stirred anxiety in high-yield debt but subsided with the dovish message from Fed Chair Janet Yellen that month. Even if these watchers of the crucial junk market are correct that it will hold together for longer, it's logical to expect the stock market to undergo a test of some description. Oil has gone from hated asset about which the bad news kept flowing to an overbought market ridden by momentum traders and goosed by a spate of bullish supply headlines. Whether a true shift or not, perception on China policy has gone from "all-out stimulus" to "containing financial excesses." And, as noted, those overbought "safe" yield sectors of the stock market are pulling back as Treasury yields perk up a bit and valuations got stretched. The positive for now, and for as long as it lasts, is that some cyclically geared parts of the market have held up better, though the trend is immature and tentative yet. Source: FactSet A key question is not whether the market will undergo a possibly messy adjustment to a new "storyline" if the dollar-oil-credit-yield tail winds shift. Maybe that's what is already underway below the surface. But are investors, collectively, already worried and defensive enough that bad news would elicit a shrug from the market rather than a scream? Strategists at Merrill Lynch and Goldman Sachs came into the week emphasizing downside risks to clients. The new monthly Merrill global fund manager survey showed cash levels on the high end of their historical range. Stiff outflows from equity mutual funds and ETFs persisted through last week. Meantime, Mark Sebastian of OptionPit.com is among those remarking on the heavy demand for futures and options on the CBOE S & P 500 Volatility Index (VIX) by traders betting on a stormier market in coming months. This has the effect of suppressing the VIX itself, while somewhat cushioning the impact of future market sell-offs. "When the market is ready for a sell-off, they rarely happen," Sebastian notes. But is it truly ready? Stocks seem a bit like a ball balanced on a seal's nose, looking precarious and reliant on a precise sequence of muscle contractions. But don't those guys always seem incredibly able to balance that thing for longer than you'd expect?

Pascal Guyot | AFP | Getty Images

It's not the waxing prospect of a Federal Reserve rate increase that has the stock market on edge Wednesday. Not directly, anyway.

After all, investors should be encouraged by the conditions that are prompting Fed officials to keep two, or even three, rate hikes in play for this year: The job market's tightening, wage growth is quickening, deflation fears are waning and global financial footing is more stable.

What really accounts for the fitfulness of equities in recent days is the way those gently revived rate-hike expectations sharpen the focus on the ticklish balance of factors that have allowed stocks to hang within a few percent of their all-time highs for months now.