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Wednesday Look Ahead: Can Stocks Hold Uptrend after Fed Throws Cold Water on Recovery?

Tuesday, 10 Aug 2010 | 9:37 PM ET

The Fed signaled a dimmer view of the economic recovery and reverted to extraordinary policy moves.

AP

Yet, stocks had a slightly positive reaction, and traders are wondering whether the stock market can hold onto its uptrend.

As expected by some economists, the Fed said it would reinvest principal payments from its maturing mortgage securities into the Treasury market.

Stocks Tuesday recovered some losses after the 2:15 p.m. Fed statement, and even more buyers rushed into the bond market, driving yields lower. The yield on the 10-year slipped to 2.779 percent. The dollar gained 0.3 percent against the euro but ended off its session highs, with the euro at $1.3184.

To some strategists and economists, the move was more symbolic than anything. "I guess the point is the Fed is really trying to accomplish this to keep us away from deflationary forces. Anything to get a little inflation into the system is a good thing and positive. Buying the Treasurys will expand the money supply and essentially that's the real accomplishment of this. It's not really a game changer," said Andrew Burkly, market strategist with Brown Brothers Harriman.

The near term reaction in bonds is likely to be lower yields, strategists said. The Fed has targeted durations between the 2- and 10-years. Economists say the Fed program will result in keeping its $2 trillion balance sheet from shrinking with the purchase of between $200 to $300 billion securities through 2011.

Just as economists debated whether the Fed would reinstate quantitative easing ahead of the meeting, they are now debating whether the move is a "baby step" toward a bigger asset purchase program, as Goldman Sachs economists wrote Tuesday. J.P. Morgan economists, however, wrote that they believe the chance of the Fed embarking on a much bigger program is low.

"We had not expected it to be this month. We expected they'd lay the ground work for it for next month. To me, it shows they're more nervous about their growth outlook than we had thought. The market had priced it in, to some extent. The surprise was they plan to buy Treasurys of longer duration than 2-(year)s and 3-(year)s," said RBS Treasury strategist John Briggs. "We, as a house, called for 2.75 (10-year yield). Now that we hit that, we're certainly going to look at our forecast over the next several days."

Traders will be watching the Treasury's $24 billion 10-year auction with special interest Wednesday, since the Fed's announcement may complicate it. The $34 billion auction of 3-year notes was well bid Tuesday.

Wednesday's markets face little in the way of economic data, with June international trade reported at 8:30 a.m. There are still some earnings, including Cisco's after-the-bell report. The report comes after a sloppy day for technology stocks, with chips hit the hardest on concerns about falling PC sales. The S&P technology sector was down 1.2 percent, and Intel lost 4 percent after a downgrade from J.P. Morgan.

Disney reported after-the-bell earnings Tuesday, and could get a lift in early trading from its earnings beat. Cree, however, reported aweaker revenue forecast for the current quarter after reporting a big jump in profits.

Whither Stocks

Burkly believes stocks will continue to trade in a choppy fashion through the end of the summer. "It's almost become more a concession now, but it really seems to be that we're following midterm elections in the stock market. That really means weakness until mid September. You then put in the the low and that's the start of a rally," Burkly said.

Analysts and traders say 1130 on the S&P 500 is the level to watch. "We still think they're kind of stuck in a range here, but we do think there's upside. We do think we're going to break that 1130 on the S and P," he said.

"It was the rally peak in June. We've hit it five or six times in the last week and a half and have really been unable to press through that. It's one of those levels that people are looking at. If we were able to push through it, some of the shorts would get squeezed and we might get some momentum on the upside," he said. Burkly's target is 1250 for year end.

Bonds vs Stocks

Wells Capital Management chief investment strategist James Paulsen said he was not surprised by the Fed, but was instead by the stock market's reaction. "The internals went recession," he said. "What I mean by that is bonds outpaced stocks and within the stock market, all the economically-defensive sectors were up and all the economic sensitive sectors got clobbered. Moreover, commodities were off big and the dollar lost its bid of earlier in the day."

Paulsen said the stock market is now dependent on improvement in economic reports to get a real lift. He does expect low bond yields to help stocks , even if they signal a troubled economic outlook to some investors.

Steve Massocca of Wedbush Securities agrees low yields could actually help stocks, and that yields may move even lower. "It (10-year yield) was 2.08 in December, '08, and it certainly can go lower than this," he said.

"Relative to investing in government securities, it certainly makes equities a more compelling value," he said.

"I think the argument that's somewhat negative that people will talk about is this is kind of what happened in 2007/2008. You had the stock market predicting one scenario and the bond market predicting another outcome. Then the bond market was right. The last time this happened you would have been better off listening to the bond market than listening to the stock market," he said.

Paulsen points out it is also similar to 2003 when the message from bonds and stocks were diverging. "The 10-year got down to 3 percent. At the time, 3 percent was almost unheard of, but we had a deflation scare," he said. Stocks ended up being the market to follow.

- Follow me on Twitter @pattidomm.

Questions? Comments? Email us at marketinsider@cnbc.com

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