Stocks could have a rough ride into summer, as the Fed steps back from its quantitative easing program and the economy stumbles through a soft patch.
Stocks Tuesday were barely changed after a volatile sell off Monday on concerns about Europe's sovereign debt crisis, a lingering worry that periodically rattles the markets.
The S&P 500 is now down 3.5 percent for the month of May, and analysts expect the market to continue trading in a choppy fashion. They say stocks could move lower before heading much higher, but this is not the start of a steep correction.
"I think this is just going to be a very sloppy investing season, and one where you're not going to be rewarded for being early," said Jack Ablin, CIO of Harris Private Bank.
Stocks and other risk assets have been locked in a trade where they move in tandem with the euro. Risk assets benefited from the launch of the Fed's quantitative easing program, but have sold off in the last several weeks, ahead of the completion of the program at the end of June.
"I do think we're in a cyclically sideways market which means you really do have to play this risk on, risk off trade," Ablin said.
Brian Rauscher, chief portfolio strategist at Dahlman Rose and Co, said he expects a major correction at some point but does not believe this is the start of it.
"The buyers right now have no reason to step up and be aggressively purchasing here. We're out of the earnings season and there is no catalyst. This market has been very resilient at these technical levels," he said.
At its lows of the day Monday, theS&P 500 touched a key level—1313—before moving higher. "You break this 100-day moving average (1313), and you'll get some selling," he said.
"If you're an investor, I don't think anything's really changed...We still think the market will go higher but we think on a path, we will go lower before we go higher," he said. Rauscher said this sell off could be similar to the 5-7 percent pull backs that have characterized this market since it began to rise in March, 2009.
Rauscher said if the market does sell off sharply, the chances of the Fed pursuing another quantitative easing program would rise dramatically. The Fed, in its latest program, is purchasing $600 billion in Treasury securities.
"If the market can stay above 1300, the probability of QE3 is 10 percent," he said.
Andrew Burkly, director of equity research at Brown Brothers Harriman, expects the market to stay in its choppy, lower trend until July or August.
"We're bracing ourselves for something we think is a typical 'sell in May' and go away. That's what we think we're in and we don't think it's over. It's not a bull-market-ending bear market," he said.
Burkly said he made some portfolio changes and moved more heavily into defensive stocks, like heath care and consumer staples, while staying away from higher beta sectors. "Our overall thesis for the year has always been that the economic growth expectations got too far ahead of themselves," he said.
Burkly said U.S. data has also been a big factor in the market's choppiness, and the 2011 GDP forecasts of economists have now slipped to a consensus 2.7 percent from 3.3 percent. "We think that's the trigger. All these growth forecasts are being pared back," he said.
Burkly said he is watching the 1295 level on the S&P as the next big support area, and that the S&P could fall to his low forecast for the year of 1230 before rebounding.
Standard and Poor's Sam Stovall is also watching that 1295 level, but he's not ready to say the market is headed for much of a decline.
"It's an important level that we might bounce off of," he said, noting it is a key retracement level and also would be the point where the market is down 5 percent form its April high of 1363.
"My gut basically says that for right now it's too early to push the panic button. It's like listening to a pilot say: 'we're approaching turbulence. Please put on your safety belt.' She is not saying: 'Don your parachutes and assemble by the door,'" said Stovall.
Stocks and commodities have also been sensitive to any signs of slowdown in China and reacted negatively to weaker manufacturing data early Monday.
"I think certainly that if the decline in equity prices combined with the decline in commodity prices and the decline in 10-year yields, you can't ignore them because they could be signaling an economic slowdown to occur six months form now. At the same time, if you keep responding to these type of minor dips, you're going to be whipsawed. Unfortunately the fundamentals don't reveal themselves until much of the price change has already occurred," Stovall said.
One thing analysts agree on is that the strength of earnings puts a floor in the market. Rauscher said the earnings backdrop for the remainder of this year and early next year should remain strong but could then weaken if the economy weakens. "It looks like there's enough earnings power to put a floor under the market at 1250/1220ish area," he said.
Rauscher said he is also favoring defensive sectors, but is watching for signs the market is shifting so he can recommend moving back to cyclicals once more. "My work is saying they are going to underperform for another four weeks or so," he said.
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