The Fed Takes Off the Economy’s Training Wheels

by Bryan Perry | May 1, 2012 8:00 am

Last week Fed Chair Ben Bernanke reiterated the Federal Reserve’s recent position that, although the housing and labor markets remain strained, there’s enough broader evidence (both anecdotal and empirical) to maintain that further quantitative easing is unwarranted now. But the macro data from this suggested otherwise, as several data points came in light of expectations:

However, there were some nuggets of good news emerging from the housing market. Home prices still fell on a marginal basis across the country, but new home sales for March came in above consensus at 328,000 versus 320,000, and pending home sales for March rose 4.1% versus consensus of 1.0%. So there’s a pulse in the housing market after all. Maybe this is some of the evidence the Fed had on hand when issuing its policy statement.

At the same time, Bernanke made it quite clear that the Fed is ready to embark on QE3 if the economy deteriorates from its nascent recovery. This kind of language is bullish for stocks and underscored the rally we’ve seen this week for U.S. indexes. Robust earnings from America’s leading companies, combined with the Fed being vocal about providing more liquidity, has the S&P back up over 1,300, which is 2.2% off the 2012 high of 1,422.

Earnings have been coming in generally above expectations: Of the roughly 200 S&P 500 companies that have reported Q1 numbers, 80% have beat estimates. But when earnings season slows, the market will have to depend on the economic calendar to provide catalysts for a higher move-up.

We also face the “sell in May and go away” mantra that’s sure to splash across every business media channel.

Across the pond, European markets have rallied alongside ours as the notion of growth and austerity by the European Central Bank and Germany permeates investor sentiment. Just seeing those markets stabilize to some degree is hugely important to the overall investing landscape. It allows investors to rivet their attention on the U.S. economy, which is showing clear signs of improvement, although at a slower pace than in the first quarter.

The tale of two very different schools of thought is still quite visible as to future market expectations. On the one hand, the risk-on trade of legging into equities has delivered a 10% return for the S&P for 2012 to date. On the other hand, yields on Treasurys are right back down to last year’s levels, when the European debt crisis had that Lehman-moment look about it.

My take is that one school believes the Fed will keep its foot on the gas and Congress will pass a continuing resolution to keep the tax cuts from expiring at the end of the year, opting to deal with this highly charged issue sometime in 2013. The bearish camp is seeing more ineptitude on Capitol Hill and a deepening of the European debt crisis in the months ahead.

I can appreciate both lines of thinking, and this is why, if red flags start to pop up in the weeks ahead, we have to be proactive and take action to protect our principal.

Recently I laid out how we would hedge downside risk with the ProShares UltraPro Short S&P 500 ETF (NYSE:SPXU[1]) if it’s warranted.

Investor sentiment is bullish for the moment, having re-emerged this week; whether it has staying power will be spelled out in the days ahead. The first quarter report card for corporate America is looking like an honor student making the Dean’s List. A lot can still go wrong — but fortunately, a lot is going right for investors who are long this market.

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