Week Ahead: Outlook for Stocks Volatile, with Headwinds

Choppy, with political headwinds and chillier credit conditions, is the forecast for stocks in the week ahead.

Broker works the trading floor at the New York Stock Exchange.
Broker works the trading floor at the New York Stock Exchange.

Markets come off a volatile week that saw heavy selling and violent swings in risk assets of all types. Investors piled into the safety of U.S. government bonds, pushing yields sharply lower. Spreads between Treasurys and other credits, like investment grade and high-yield corporates, mortgages and emerging markets all widened, and the closely watched London interbank offered rate (Libor) continued to creep higher.

Currencies called the tune, as the euro swooned to a 4-year low and then recovered to $1.2574 Friday, gaining 1.5 percent against the dollar for the week.

Stocks officially crossed into correction territory Thursday for the first time since the 14-month rally began. For the week, the Dow lost 426 points or 4 percent, to end at 10,193, while the S&P 500 shed 47 points, or 4.2 percent to 1087. The Nasdaq lost 5 percent of its value, or 117 points to 2229.

"I think it's going to be more stable this week, but relative to most weeks this year, it will be a volatile week, and we'll probably get a move in both directions," said BlackRock Vice Chairman Bob Doll.

"The question is do all of the confluence of events, meaning monetary tightening fears; the credit issues from Europe and political issues in the U.S., do they overwhelm the cyclical recovery? Or are we still having a recovery? My bet is the latter," said Doll.

Doll said he expects the heightened volatility to remain for now, and he would rethink his view on the recovery if stocks head much lower. But, he also said it's possible stocks may have gotten close to a near term bottom.

"The correction from a 'point' standpoint could be pretty much finished, but we could still bounce around and take some time for investors to get conviction again," he said.

What to Watch

In the coming week, the Treasury will auction $113 billion in 2-year, 5-year and 7-year notes Tuesday through Thursday. Markets will on alert for headlines related to the European sovereign debt crisis and U.S. financial regulatory reform. There will also be interest in news from China, where U.S. Treasury Secretary Tim Geithner and other officials attend the Strategic and Economic Dialogue Summit.

There's a long list of economic reports on next week's calendar including housing data, but most of it could be overshadowed by the behavior of financial markets themselves. Economists are increasingly worried that the searing decline in risk assets, and the parallel creep up of rates in the interbank lending market and the widening of other credit spreads will have a negative effect on the economic recovery.

Credit Re-Crunching?

The renewed chill around credit markets, and the steep decline in risk assets bears watching, according to Citigroup economist Steve Wieting. Compared to late 2008 when markets reacted to the collapse of Lehman Brothers, the cooling off of credit markets is mild, more like a light frost. Wieting notes also that the underlying economy is not on the same path of decline it was on at that time.

"It's pretty clear to us...that financial conditions lead demand in the economy, which then leads production, employment and investment," he said. "The fact we have employment gains now has been building for over a year, and basically confirms the upturn in easing financial conditions and the improvements in profits."

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

"There's a lot of speculation about right now, and the imagination goes wild. The actual dislocations thus far have not, to date, been monstrous. A 10 percent stock market correction is not a 50 percent correction," he said.

Wieting said, however, the shift in financial markets have changed the outlook for many investors who thought the economy would outpace expectations. ""It's been an amazingly swift revision to expectations," he said, noting that there is now more risk to the downside for economic forecasts. "What is important is just a few weeks ago it seemed that the balance of risks were to the upside."

Nomura Treasury strategist George Goncalves said in addition to the $113 billion in notes auctions, the bond market is also focused on interbank lending rates and other signs of stress.

"Next week, as long as it's steady and we don't have these violent moves like we did this week, if things stabilize, then it could be a good scenario for both (bond and stock) markets. But it's still too early to call that conclusion. I'm still betting the funding markets aren't operating properly. I still think there's another shoe to drop in the European banking system," he said. Goncalves said 3-month Libor/OIS has gone from a low of 0.8 to 0.27 in the past month, and it continues to rise.

"The rating agencies haven't downgraded the European banking system, but the rate markets have because libor keeps going up," he said. "There's a premium European banks are paying to get access to dollars, and that's been the case since August, 2007 and it hasn't gone away. It's a relic of the credit crunch and it's just coming back to the fore."

Kevin Ferry of Cronus Futures Management said, however, the moves in credit markets were to be expected and are not that extreme. "There is no funding problem for dollars or euros in the world today. It's just not there...You see the market, from a timing perspective, is making adjustments and moving toward a new world," he said.

"If the credit spreads were getting any worse, we would think they were getting out of hand...I think it's going to die down," he said. Ferry said he thinks high yield and other credit markets will stabilize and the low yields of the summer for Treasurys will be seen within the next few weeks. "That's going to correspond to stability in the risk markets and in the funding markets," he said.

More From CNBC.com:

Watching China


Besides housing data, Thursday's weekly jobless claims, which disappointed this past week, will be closely watched. Claims were reported this past Thursday at 471,000, up 25,000. "There's not a good explanation for it...had we not had four consecutive weekly declines right behind it, we would be very concerned...If we had several weekly rises in claims, I'd be very concerned," said Wieting.

The first housing report in the coming week is Monday's existing home sales. Tuesday's release is the S&P/Case-Shiller home price index, and on Wednesday, new home sales are reported.

Other data includes consumer confidence on Tuesday; durable goods Wednesday; and a second look at first quarter GDP Thursday. On Friday, there is personal income, the Chicago purchasing managers survey and consumer sentiment.

China Chilled?

China will also be an important focus in the coming week. Given the moves in currency markets, China is now unlikely to make any move to allow its currency to appreciate, as foreign exchange strategists had previously expected.

"I do think there will be trade concessions, but I don't think there'll be much on the currency. China exports more to Europe than it does to the U.S., and commodity prices suggest that China won't be experiencing inflation for very long, so why would China move on its currency when its export outlook is challenged and the outlook for inflation is tame," said Marc Chandler, chief currency strategist at Brown Brothers Harriman.

A major worry in markets has been that China will be too successful slowing its growth engine, as its tightens bank lending and takes other steps to slow down. The impact from a slower Europe on China has also been a concern.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Doll said he's not worried about China. "China is hell bent on slowing its economy. They'll be successful. On skittish days, investors say they'll slow it from 12 percent to 2. My bet is they slow it and it will settle in the 8 percent range," he said.

Doll does not expect much in the way of news from the summit. "It'll probably get lost in Europe and the financial regulation shuffle, But I think it'll be a lot of closed door conversations about currency and progress in trade," he said.

Bank Reform

Financial regulatory reform legislation, approved by the Senate Thursday, is now heading to a bipartisan committee that will resolve differences between the Senate and House versions of the bill. House Speaker Nancy Pelosi may now wait until after Memorial Day to begin those discussions, according to aides quoted by Reuters.

Bank reform was seen as one of the negative factors that threw stocks into a tail spin in the past week. The S&P financial sector was down 3.9 percent for the week after a 3.6 percent rally Friday.

Markets Mayhem

Global stock markets fared no better than U.S. stocks in the past week. Tokyo stocks were down 6.5 percent. The Shanghai composite was down 4.2 percent, and is now in bear market territory, down 21 percent from its January high. German stocks lost 3.8 percent, and the U.K. FTSE was down 3.8 percent. The S&P is now down 10.6 percent since April 23, but is still up 60.8 percent from the more than 12-year low it hit on March 9, 2009.

Oil lost 7.2 percent for the week to $70.04 per barrel. Even gold was blasted in the "de-risking" sell off, and ended the week 4.2 percent lower at $1175.70 per ounce.

The VIX, the Chicago Board of Options Exchange's volatility index, jumped sharply to a high of 48.20, but finished at 40.10. The VIX reflects implied volatility, using options on the S&P 500 index, and is viewed as a 'fear meter' for the market.

"Everybody was trying to get in the middle of the herd and feel like they were being protected, and then the herd goes off a cliff and really that's what it's been like," said Patrick Kernan, who trades S&P 500 options for Cardinal Capital at the CBOE.

"We got down to 1050 (on the S&P) today," he said Friday. "I think that's a good signal we bounced off that, but I certainly don't think that removes any of the volatility. I think there's going to be choppiness. I think people are skittish, and I think people are definitely afraid of what's out there."

Kernan said investors are now willing to pay more than four times as much for 10 percent out-of-the-money puts versus 10 percent out-of-the-money calls. That is about the highest level he's seen and double the usual cost for downside protection.

More From CNBC.com:

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