March Madness: Cyprus May Give the Fed More Ammunition

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Cyprus and ongoing concerns about the Eurozone's debt crisis may mean a pause to the U.S. equity rally, but it shouldn't undermine the broader advance, say market watchers, as many expect the Federal Reserve's aggressive bond buying to continue.

"Despite the muted reaction so far, Europe has reminded investors that there are significant problems behind the curtain," JPMorgan's Alex White wrote in a research note.

They tiny island of Cyprus rattled global markets on Monday, after news broke that conditions of a bailout included seizing money from depositors.

(Read More: How Tiny Cyprus Could Still Have Big Market Impact)

That has put pressure on stocks and may prompt a pullback of up to 5 percent to 10 percent, said Jeff Kleintop, chief market strategist for LPL Financial.

"After all, it's time for March Madness," he said. "March has been maddening for investors in the past few years as the S&P 500 raced higher in March only to reverse all of those gains in a pullback of about 10 percent that began in late March or April."

(Read More: Cyprus Can't Put 'Genie Back in the Bottle': O'Neill)

But it might not be Cyprus or a major headline that starts a correction, Elliot Spar, market strategist at Stifel Nicolaus said. "I continue to believe it will come from the technical side in the form of an increasing number of negative divergences, an increasing number of consecutive days of lagging NYSE breadth or a key reversal day in the major averages," he said.

While many market watchers have been calling for a correction after this year's run-up in stocks, Europe's woes make U.S. stocks relatively more attractive, David Joy of Ameriprise Financial told CNBC. "I wouldn't necessarily be buying anywhere other than the U.S. market and maybe Treasurys a little, a little bit of gold," he said.

Meredith Whitney echoed those comments in a separate CNBC interview, saying the European debt crisis likely will be beneficial for U.S. assets. "I have not been this constructive, this bullish on the U.S., on equities in my career," she said.

(Read More:'You Have to be Bullish,' on US Stocks: Whitney)

Fed Meets

Heading into the start of a two-day Federal Reserve meeting on Tuesday, Cyprus may also give the central bank's doves more ammunition to continue their quantitative easing program of buying government bonds.

In minutes from the last Federal Open Market Committee meeting, the Fed noted that "strains in global financial markets" could be a downside risk to economic growth and possible reason to provide ongoing monetary stimulus.

(Read More: Why Fed's Role as Fiscal Shock Absorber Is Ending)

Stuart Hoffman of PNC Financial Services told CNBC the Cyprus turmoil should give Fed chief Ben Bernanke the cover to continue the $85 billion in monthly bond purchases. "Even if this is temporary and doesn't affect GDP it's a strain in financial markets," Hoffman said.

The Federal Reserve will release its policy statement on Wednesday at 2pm ET with Bernanke's press conference to follow at 2:30 pm. Even as the problems in Europe persist, with a slowly improving U.S. economy, investors will be looking for any clues as to when the Fed may begin to withdraw some of its monetary stimulus.

(Read More: Fed Throws Junk Bond Lifeline to Weak Companies)

BofA Merrill Lynch's Michael Hanson expects little change to the FOMC statement. "That said, revisions to the economic projections are likely to appear hawkish, given the better U.S. data of late," he wrote in a research note. He's focused on Bernanke's press conference, writing "Based on his recent speeches and testimony, we expect on net dovish remarks that support our expectation for QE3 to continue well into next year."

The Fed and markets will also get a sense of how the housing recovery is progressing when the housing starts report is released at 10 am on Tuesday. According to Reuters estimates, economists are looking for February housing starts to increase to a 915,000 annual rate from 890,000 in January.

A Wall Street Bear Gives Up

As the housing market recovers and U.S. economic growth continues to surprise, a noted Wall Street bear has changed his outlook. Morgan Stanley's Adam Parker took his 2013 year-end price target for the S&P 500 to 1600 from 1434, as he sees "improving fundamentals in the second half of the year and into next year," he wrote in a research report on Monday.

Parker sees only two reasons for a major market correction in the coming months: fear that earnings will be substantially reset or investors starting to worry that positive economic data will mean the end of quantitative easing.

The research departments at other investment banks are also boosting year-end targets after a 9-percent run in the S&P 500 so far this year. Goldman Sachs raised its year-end S&P 500 target 50 points to 1625 on Monday, implying a 4-percent increase in the S&P.

Goldman recommends going overweight on cyclical sectors, with a focus on financials. "Accelerating economic growth, improving ROE (return on equity), rising rates, and increasing dividends and buybacks will drive outperformance for financials in 2013," the Goldman strategists wrote in a research note.

With economic conditions improving, Wall Street optimism rising and the Fed providing supportive monetary policy, stocks may continue to run.

"Last year, a lot of people thought the economy would be bad this year and a lot of analysts and investors are realizing that things are better than they thought they were going to be," said Gary Thayer, chief macro strategist with Wells Fargo Advisers. "That's why we're seeing some of these upward revisions to forecast on the market and the economy, and you know, that can be a healthy thing."

— By CNBC's Justin Menza; CNBC's JeeYeon Park contributed to this story.