As Economy Falters, Worries Grow That Stocks Will Follow

Along with the feeling that the economic recovery isn't all it was cracked up to be has come a feeling that maybe the stock market rally isn't, either.

NYSE traders
NYSE traders

What pros call a "negative feedback loop" has taken control of trading, where a relentless spate of bad economic news has triggered a wave of pessimism that feeds on itself even on a day when the news cycle doesn't seem to justify selling.

Nowhere was the trend more evident than Tuesday, when Fed Chairman Ben Bernanke delivered fairly innocuous remarks that nonetheless triggered a selloff in the markets and added to a dismal June for the market.

The market drop, though, was typical of trader behavior lately.

"My biggest concern is more that the economy is susceptible to a feedback loop, meaning that consumer confidence, spending, business confidence are probably more fragile than we thought," BlackRock fund manager Eric Pellicciaro said in a CNBC interview. "You're open to wealth effects. If the equity market should take a 4 to 5 percent hit, I think your second half is going to be a whole lot worse."

Pellicciaro said the potential for disruptions has the firm believing that Treasurys will continue to provide sound protection, despite their anemic yields.

In a suddenly unpredictable market, the S&P 500 has shed much of its earlier 2011 gains and is up just 2 percent so far. However, the average has fallen 6 percent since hitting its post-financial crisis high May 2.

Economic news, particularly a second leg down in housing prices, weak jobs numbers and renewed fears over European debt, have been the primary culprits behind the fall.

The market turned to Bernanke's remarks, which were punctuated with a downbeat assessment of the economy and fairly clear indications that while the Fed is unlikely to abandon the financial markets, its days of aggressive intervention were over, at least for now.

The Fed's position is considered critical because a Bernanke speech in Jackson Hole, Wyo., late last August in which he indicated more intervention was coming served as the key catalyst for the latest rally. So an ambivalent Fed comes as a bit of a jolt to the market, even though strategists have been saying for months that they didn't anticipate what is widely referred to as "QE3," or a third leg of Fed asset purchases, was likely.

"This disappointment is hardly surprising given the boost to equity prices that the first two rounds have provided," John Higgins, senior market economist for Capital Economics, said in a note to clients. "We think that QE3 is unlikely to see the light of day this year, and that equities are likely to struggle even if the economy picks up some steam."

Higgins said he considers stock valuations to be "stretched" and projects the S&P 500 to end the year at 1200, a 6.7 percent tumble from current levels and well below consensus, which has the index closer to 1400.

David Rosenberg, economist and strategist at Gluskin Sheff in Toronto, was even blunter about the state of the markets.

"Equity rallies of over 100 percent over two-year intervals that are premised largely on government intervention are doomed to fail," he said in an analysis.

That leaves both short-term traders and longer-term investors in a quandary over whether the economy will remain the major theme for markets or if the state of the corporate balance sheet will dominate.

"You have this tug-of-war between the macro economic news, which is negative and doesn't look to be changing, and the micro news, which is company-specific," said Philip Silverman, managing partner at Kingsview Management in New York. "US corporations are doing quite well in terms of how they shored up their balance sheet, tightened their belts and profits are staying high."

It adds up to a market that could see a bounce as another earnings season approachesbut otherwise will be full of peaks and valleys.

"Rather than think about the market going up and down, we're going to continue to see a very choppy market," Silverman said. "We're looking to keep our risk tight and take advantage of short-term trading opportunities."

Indeed, broadly speaking investors have turned increasingly bearish since early April.

The latest Investors Intelligence survey, which gauges the sentiment of newsletter editors, has seen bulls fall to 40.9 percent, the lowest since the rally began in September. Still, bearishness remains relatively low at 22.6 percent, though that is the highest since late March.

The poll, generally seen as a contrarian indicator, has a spread that does not indicate excessive bearishness but rather a strong level of caution.

"The stock market newsletter editors are no fools and they are also increasingly worried for stock markets and the country," said John Gray of Investors Intelligence.

The ability of Bernanke and others to assuage investor fears, then, likely will determine whether the rally will resume.

"You're burning off some froth, you're burning off some excesses in the market and the market is going to be recalibrating to earnings," said Quincy Krosby, market strategist at Prudential Financial in Newark, N.J. "It's a period of caution."