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Economy Falters, Stocks Tank: What's an Investor to Do?

When the US economy was showing signs of life, the end of Federal Reserve's easing didn't seem to worry financial markets. But now that the economy is clearly sputtering, the transition may not be so easy.

After all, this month's end of the Fed's quantitative easing measures—known as QE or in the latest phase QE2—hinged on an economy ready to take off the training wheels.

But this week's economic news—including Wednesday's disappointing reports on employment and manufacturing— has stirred worries that the economic lynchpin instead may be a trap door.

For investors, that means that if the economy cannot stand on its own, financial markets will be vulnerable to a sharp pullback.

Investors clearly showed their concern on Wednesday. Stocks tumbled following the weaker than expected economic news, while the flight to safety sent the yield on the 10-year Treasury below the critical three percent level.

"The underlying economy is the biggest driver of the markets at this point," says Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "If this economic soft patch continues then you're most likely going to see earnings estimates come down and you're going to see the market move lower. How much depends on if it's just a lengthy soft patch or the beginnings of the next recession."

For now, more advisors are in the former camp than the latter—that is, they see the current slowdown in economic dataas another typical gyration in a fairly nascent recovery.

Flam worries that investors will feel the impulse to follow the undulating wave of market emotions and make bad decisions.

"Last year was uneven, this year is uneven. The mentality is, when things are good everybody feels good and wants to buy stocks, and when things are bad everybody feels bad and wants to sell stocks," he says. "In a range-bound market that's the worst thing you can do. You end up buying high and selling low. You have to counter your instincts."

An oft-mentioned template, in fact, is 2010, when the market surged the first four months of the year. A tailspin caused by the first wave of European debt default concernslasted through the summer and into the waning days of August.

At that point, Fed Chairman Ben Bernanke delivered a landmark speech in Jackson Hole, Wyo., that sent a clear signal the central bank was preparing another round of easing. Markets jumped on the news then pushed even harder once the Fed announced another $600 billion in Treasurys purchases at its November meeting.

Whether the market receives some similar type of kickstart, or if the economy simply needs time to work out its problems, the perceived direction for stocks is higher into the end of 2011.

"There are certainly some similarities right now to what we saw a year ago. People are getting concerned and rightfully so," says Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinatti. "The concerns are valid. At the same time, our overall stance is looking at expectations, they're too low for a market that's been really strong for a little over two years."

Though investors have had plenty of advance warning and thus time to price in the end of QE2, the summer by many accounts is likely to be a bumpy one for the market.

"We're shopping around and not doing much from a trader's point of view," Detrick says. "We are shortening our time frames because there are opportunities on both the bear and bull sides."

One area Detrick is focusing on is the financial sector, which he feels likely would get hit harder by a market downturn.

That jibes with a recent Standard & Poor's analysis which concluded that the double-dip in housing likely will siphon $70 billion to $80 billion out of bank earnings by the time it is over.

That's not a pleasant prospect for a stock market that is generally slow in the summer anyway.

A separate S&P analysis points out that the so-called summer rally—the lowest close in May to the highest close in June, July or August—is historically the weakest for the Dow Jones Industrial Average all year.

Enthusiasm for stocks, however, is unlikely to last if the economy continues to falter.

"We believe the stock market is starting a shortterm, counter-trend rally," Mark Abeter, S&P's chief technical strategist, wrote in a note to clients. "However, once the bounce runs its course, we see a resumption of the downtrend that started early (in May)."

Should the downtrend get severe enough, that might bring the Fed back in from the sidelines.

"Not only is the European debt crisis intensifying, but traders are likely to keep selling shares in anticipation of the end of QE2 less than five weeks from today," market research firm TrimTabs wrote in its weekly analysis. "We expect the Fed to announce QE3 as soon as late this summer. Until it does so, however, we think stock market investors will be in for a rough ride."