David Joy: All eyes on Chairman Bernanke

The S&P 500 has followed a pattern of ups and downs ever since confusion over the Fed’s intentions became an issue in May. This week the Fed gets another chance to communicate more clearly. The Federal Open Market Committee (FOMC) meets on Tuesday and Wednesday, but importantly, this meeting will be followed by a press conference, providing Chairman Bernanke an opportunity to clarify the Fed’s thinking, and settle financial markets in the process. Whether he succeeds remains to be seen. Either way, expect no change in policy. The recent economic data has been better than it was earlier in the spring, but almost certainly has not been strong enough to convince the Fed to change. This also likely means the July meeting is out as well for any change, since any economic improvement will not have persisted for long enough to be convincingly sustainable. Bernanke is likely to re-emphasize that the path of policy is data dependent. He is also likely to point out that even after any tapering of quantitative easing begins, monetary policy will still be quite accommodative, and interest rates are likely to remain near zero for a considerably longer time. It would be great if he went so far as to point out that the gradual removal of Fed accommodation is exactly what we should all want.

Unless the Fed springs a surprise on Wednesday, U.S. stocks remain attractive. So far, support has held at the 50-day moving average and if the news from the FOMC is copacetic, the trend higher should remain on track. The economy has a chance to accelerate somewhat in the second half of the year, making revenue and earnings growth forecasts within reach. The worst of the drag from spending cuts and tax increases will begin to dissipate, consumers’ net worth has now fully recovered from the recession and risen to a new high, capital investment should improve, inflation remains low and the Fed remains exceedingly accommodative. One important question is whether the recent strength in cyclical groups can be sustained. The pace of activity, particularly in the domestic economy, will likely determine the answer. Improving activity at home should benefit the financial and consumer discretionary sectors. Technology and industrials are not getting much help from overseas, but should still benefit from an improving outlook. Materials may not benefit to the same extent, given the slowdown in China and anticipated strength in the dollar. If cyclicals do retain the leadership, what about the more defensive, so-called bond proxies? In the case of utilities at least, they suddenly look more attractive after a steep decline since the start of May. The XLU ETF has declined 8% since then, but in the process its twelve-month dividend yield has increased to 3.8% from 3.5%. The same kind of reaction has been seen in the bond markets, particularly high yield. Uncertainty about the Fed, rising interest rates, and mixed economic data have pushed yields in the sector higher by 65 basis points in the past five weeks. And they, too, look a little more attractive as a result. If stocks resume their ascent, particularly in cyclicals, high yield bonds should rally as well.

The Fed meeting isn’t the only event of note this week. Scheduled economic releases include housing data on starts, permits, and existing home sales, all important to the Fed’s determination of future policy. Regional manufacturing surveys from New York and Philadelphia hold heightened importance after the national ISM index contracted in May for the first time since last November. And the index of leading economic indicators is expected to be up for the second straight month and the seventh month in the past eight.

In reality, it is really all about the Fed this week. Unless something completely unanticipated arises, don’t expect too much market movement before approximately 2:00 on Wednesday.

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