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Fed Juices Stocks, but What Could Bring Out the Bears?

Stocks could stay on an upward trajectory for the time being, while bruised bears sniff out the next trouble spot for markets.

CNBC

The Federal Reserve’s new round of quantitative easing and promise to keep policy easy well into the future propelled stocks and other risk assets higher, putting the Dow less than five percent away from its all-time high in the past week.

“For a period of time, the markets will give the central banks the benefit of the doubt,” said Barry Knapp, head of U.S. equity portfolio strategy at Barclays. “You would expect the downside would be limited over the next six weeks or so, but there’s some major questions about the effectiveness, from a macroeconomic standpoint.” (Read More: Could the Fed's QE Plan Spiral Out of Control?)

In the coming week, U.S. home sales and manufacturing data will be the focus, plus a flurry of regional Fed presidents take to the circuit with speeches on the economy and monetary policy.

Treasury yields zipped higher in the past week as investors debated the outcome of the Fed’s plan to buy $40 billion in mortgages a month. Yields climbed in part because the Fed is shifting its focus to mortgages, but also as the dollar fell and risk assets rallied. The 10-year was yielding 1.869 percent late Friday, its highest level since May 10.

“This sort of Fed action is meant to turn the corner. It’s debatable it’s going to work but in the meantime, people are going to give the Fed the benefit of the doubt,” said George Goncalves, Treasury strategist at Nomura Americas. Goncalves expects to see the 10-year yield move to 2 percent, but he says investors will continue to buy dips and yields should not rise significantly unless the economy improves.

He expects the bond market to be very focused on the economic reports, such as existing home sales and housing starts Wednesday and the Philadelphia Fed survey and jobless claims Thursday, since the market will be attempting to second guess the Fed’s take on the economy.

“They basically have taken over the bond market — Treasurys and mortgages are the biggest markets in the world. They’re willing to use fixed-income markets to subsidize the equity market,” he said. “I think the market is just digesting the implications of a hyperactive Fed that is willing to pull all stops, which means there should be some inflationary pressure priced into the Treasury market.” (Read More: Bond Buying May Be Biggest Ever)

Even with the stock market sailing higher, risks abound. Traders are watching the violence in the Middle East that resulted in the death of the U.S. Ambassador to Libya and three others this past week. Oil prices surged above $100 Friday morning but gave up some gains on speculation that there would be crude stocks released from the Strategic Petroleum Reserve. (Read More: Muslim World in Turmoil: From Libya to Yemen)

Europe will also stay in the headlines, as traders watch Spain inch toward a financial bailout. A test for Spain comes Thursday when it auctions longer duration bonds for the first time since the European Central Bank announced its bond purchase program.

What Could Halt Rally?

Stocks have racked up double-digit gains since June, despite prognosticators’ expectations that the market was heading for a summer sell off. The Dow gained 2.2 percent this past week, to 13,593, its highest close since Dec. 10, 2007. The Dow has gained 12 percent since hitting its 2012 low June 4. The S&P 500 this past week jumped 1.9 percent to 1465, its best close since Dec. 31, 2007, and the Nasdaq gained 1.5 percent to 3183, its best close since March, 2000. The Russell 2000 played catch-up with a 2.7 percent rally to finish the week at 864.

Fears of the fiscal cliff— the year-end expiration of Bush-era tax cuts and automatic spending cuts — top the list of lingering concerns that could halt the market’s climb. But there are others, including earnings slowdown. The weakening dollar, however, could help the earnings of multinationals.

“By our reckoning, the third quarter is going to be the trough,” said Richard Bernstein, CEO of Richard Bernstein Capital Management. “The rates of change should actually run more positive unless we hit a profit recession …The problems that you’re seeing I would argue are more related to the dollar and weakness around the world. Domestic companies seem to be doing okay.” Bernstein said he remains bullish and does not see warning signs of a bear trend.

Other concerns are election-related.

“I think the key for the election basically is the Congressional outcome, particularly the Senate, because the market is focused now on what happens with tax policy on dividends and capital gains. The market is looking for a Republican outcome,” said David Bianco, Deutsche Bank chief equity strategist. “If it gets one, I think the rally continues.” Republicans favor keeping the lower capital gains and dividend tax rates that expire Dec. 31, unless extended, and Bianco expects a post-election selloff if Democrats retain control of the Senate.

For now, he is also looking for an increase in volatility and a minor pullback, of about five percent after the summer run-up. “I don’t think now is the time to be chasing this rally,” he said.

Knapp said he thinks the market will begin to sputter if Wall Street-favored Republican presidential hopeful Mitt Romney starts to fall behind in the polls. “I don’t think there’s a lot of downside risk in the next four to six weeks, unless the polls go extremely south,” he said. “If the polls go toward the GOP, there’s not a lot of downside to the market for the rest of the year.”

Rising gasoline prices are also a concern, Knapp said. “If prices keep rising, that’s going to be bad for core growth, and we could have a very un-Merry Christmas this year,” he said.

What to Watch

Monday

8:30 a.m. Empire state survey

Tuesday

Earnings: FedEx

8:00 a.m. Chicago Fed President Charles Evans speaks on current economic issues

8:30 a.m. Current account

9:00 a.m. TIC data

10:00 a.m. NAHB survey

11:30 a.m. New York Fed President William Dudley on regional and national economy

4:30 p.m. New York Fed President William Dudley on regional and national economy (same speech)

6:15 p.m. Richmond Fed President Jeffrey Lacker speaks on maximum employment and monetary policy

Wednesday

Earnings: Adobe, General Mills, Autozone, Bed, Bath and Beyond

8:30 a.m.Housing starts

10:00 a.m. Existing home sales

7:00 p.m. Dallas Fed President Richard Fisher speaks on economic and monetary policy outlook in New York

Thursday

Earnings: Oracle , Rite-Aid, Conagra

7:45 a.m. Boston Fed Eric Rosengren speaks on economic and monetary outlook

8:30 a.m. Initial claims

10:00 a.m. Philadelphia Fed survey

10:00 a.m. Leading indicators

11:30 a.m. Minneapolis Fed President Narayana Kocherlakota speaks in Inwood, Mich.

Friday

10:00 a.m. BLS regional/state unemployment

12:40 p.m. Atlanta Fed President Dennis Lockhart speaks

Follow Patti Domm on Twitter: @pattidommQuestions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.