What Happened to the Rally? Why Markets Are So Worried

Even though investors seem to have gotten everything they've wanted over the past month or so—political changes, Fed help and tax relief—the markets are still full of jitters.

An Indian stock broker looks worried as he watches the screen in Mumbai, India.
Sajjad Hussain | Getty Images
An Indian stock broker looks worried as he watches the screen in Mumbai, India.

Over the past few trading sessions, bond yields have jumped, commodity prices have slumped and stock prices haven't done much of anything, despite optimism that a tax accord in Washington would be the final push the market would need to close out 2010 on a strong note.

Market pros give a variety of reasons for the market churnings, from a strengthening dollarto worries about the global economy to simple sector rotation. The prevailing sentiment is that wobbles in the various capital markets are likely to be temporary yet typical of a market where volatility should be on the rise.

"We know we had a really big rally, so it seems like we're catching our breath here. It's not like we're selling off massively by any means," says Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati.

"Most of the hedge fund managers and institutions are still underinvested and they're trailing the market for the year," he adds. "Any dips will be aggressively bought as institutions and mutual funds continue to pour money into the market to meet their benchmarks."

Some of the more interesting trading has happened in the bond and commodity markets.

The 10-year Treasury yield has hit a six-month highabove 3.25 percent on a combination of stronger economic data sapping the safety bid that fixed income attracts, and increased worries that Federal Reserve liquidity policies will generate inflation.

Long bonds are taking a beating in particular, with investors piling into the ProShares Ultra Short Lehman 20-Plus Year exchange traded fund. The ETF has jumped more than 12 percent in December and 29 percent since Fed Chairman Ben Bernanke indicated in late August that the central bank would start another round of its Treasury-buying quantitative easing program.

Yields on Treasurys jumped Wednesday but eased a bit after a modest reception for a sale of 10-year notes. Both bonds and stocks were pressured from a rise in the dollar , which gained as much as 0.5 percent Wednesday against a basket of foreign currencies.

"We think the rally in the dollar makes sense, and that investors are right to be skeptical about the implications for US equities and commodities," John Higgins, senior market economist at Capital Economics in London, wrote in a research note for clients. "We do not believe, however, that the adverse reaction in the Treasury market is likely to last."

Similarly, many investors were viewing a pullback in metalsas a buying opportunity. Gold has dropped more than 3 percent in the past two trading sessions, while silver has lost 8 percent and palladium has skidded 6 percent.

Oil also has been hit susceptible to a stronger dollar but has held its gains in recent sessions.

"Gold is a great long-term investment but is a very difficult short-term investment because of price fluctuations like we've seen in the past two days," says Matt Grossman, chief equity market strategist at the Adam Mesh Trading Group in New York. "These pullbacks are serving as great opportunities to layer in to price positions. We could come off more, but the lower we go the happier I am."

In addition to providing potential buying opportunities, the moves out of gold also could represent a sector rotation in which fund managers trying to window dress are looking for cheap stocks and other assets.

Financials, which trailed this year's nearly 10 percent stock rally, were leading the Standard & Poor's 500 in Wednesday's seesaw trading. A search for value could be a major trend as the year closes.

"The feeling is we need to consolidate in here. A lot of guys are seeing the (S&P 500) 1,200 level as a key area to hold and consolidate between 1,200 and 1,235," says Dave Lutz, managing director of trading for Stifel Nicolaus in Baltimore. "Then we're anticipating some window-dressing that could push us toward our expectations of 1,250 by the end of the year."

There also seems to be some worry over whether the tax deal between President Obama and congressional Republicans will gain enough votes for approval. The pact resolved a dispute over whether across-the-board tax cuts from 2001 and 2003 that were to sunset at the end of this year should continue for the highest wage earners.

"The left wing of the Democrat Party is about to put the economy in very real jeopardy if they do not vote to support this compromise," hedge fund manager Dennis Gartman wrote in his daily Gartman Letter. "Economic plans on the part of individuals, corporations and partnerships have to be made for the next year, and if one does not know the tax consequences of one's decisions then one's propensity to take action shall be greatly (reduced)."

The level of uncertainty is threatening a rally across markets, even at a time when many economists are raising their growth forecasts for 2011.

"Momentum is clearly subsiding despite the rampant positive sentiment, and negative divergences are highly evident," David Rosenberg, economist and strategist at Gluskin Sheff in Toronto wrote in his daily analysis. "Just as the economics community was doing radical surgery right at the July-August lows in the market, it is now raising its growth projections right at the highs. That is a contrary warning shot."