Market dip or market pit?

Unless you were shorting stocks and bonds, today’s market action was unpleasant. Is this the beginning of something bigger or just an unpleasant interruption of an otherwise enjoyable ride higher for stocks? I think the latter.

The S&P 500 Index is now where it was at the end of April. Daily drops of 2.5% or worse have only happened 1.1% of the days since January 1950. No wonder it gets so much attention!

It’s probably safe to say that many investors’ interpretations of Chairman Bernanke’s comments after the Federal Open Market Committee (FOMC) meeting triggered the sell-off yesterday and today. In theory, the sell-off should have been over with rather quickly, as prices adjusted to the new expectations of Federal Reserve (Fed) policy. Problems were likely compounded with a weak manufacturing report out of China and the late-in-the day report that the International Monetary Fund is threatening to hold back some aid to the government in Greece.

To the extent that the sell-off was due to what the Fed may or may not do, and when it may or may not do those things, I think it’s a mere dip and not a money pit. The chairman outlined the plan for how the Fed may stop its asset purchase program. If the Fed’s economic projections are correct, the plan is to slow the pace of purchases late in 2013 and stop them all together by the middle of 2014. If the Fed’s projections are correct, the unemployment rate will be 7% by the time the asset purchase program comes to an end. There is no plan to sell any of the mortgage-backed securities the Fed has purchased.

That’s the plan, but there are a lot of ifs in that plan. The chairman acknowledged how conditional the program is and stressed that the plan will change if the economic data deviate from the projections.

Perhaps I’m more pessimistic than the FOMC members, but I don’t see the U.S. economy growing by 2.3% to 2.6% for the year. The growth rate of first quarter gross domestic product was 2.4%, and I think we’ll see 1.5% growth in the second quarter. To hit the upper end of the Fed’s projections, we’d need to average 3.26% growth in the third and fourth quarters. Thus far, the Fed has been basically bragging about how low interest rates have propped up the housing market and the automobile industry (house and car purchases are rather sensitive to interest rates). With interest rates moving higher, I think it’s going to be tough for the housing market and auto industry to continue contributing to economic growth like they have in the recent past. As a result, it might be difficult to clear 2.5% growth for the rest of the year, let alone 3.26% growth.

It’s not as though the Fed doesn’t know that rising interest rates threaten to slow economic growth. It’s just that Fed officials think the increase in rates is being offset by improvements in consumer sentiment. If consumer sentiment begins to turn down and if we continue to see negative inflation readings, the Fed is likely to react by increasing, rather than decreasing, the pace of its asset purchases.

Another important factor to consider is Jim Bullard, who newly dissented from the FOMC statement. His concern is that we have deflation, not inflation. While the statement made some mentions of deflation, most of the attention during Bernanke’s press conference was on employment. This is partly because the FOMC statement said that members believe the deflationary readings were merely transitory. This indeed could be the case if commodity prices—which once distorted inflation readings to the upside—turn up again. I don’t see that happening anytime soon. Crude oil at $94 is hardly low. Corn at $5 and wheat at $7 are off their peaks but still high relative to their pre-financial crisis levels. I think we could see food and energy prices continue to come down, putting more downward pressure on inflation readings, and increasing the likelihood that the Fed will start worrying about whether inflation is too low.

With an overly optimistic Fed, higher mortgage and auto-loan rates that could drag on growth, and continued deflationary pressure, the Fed could increase its pace of asset purchases before it decreases the pace. Perhaps that would make this market dip a blip. Besides, if the Fed is right and I’m wrong, would that be bad for stocks? That would mean there’s growth! Isn’t growth good for stocks?

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