Band-Aid or cure?

Stock investors cheered the Fed's discount-rate cut and may keep cheering Monday. But beyond that, it's back to V for volatility.

By Alexandra Twin, senior writer

NEW YORK ( -- Wall Streeters got a break Friday when the Federal Reserve cut the discount rate - goosing market confidence.

What they're not likely to get a break from anytime soon though is the extreme stock market volatility that's kept them on edge for months.

Is the worst of the stock market selloff over?
  • Absolutely
  • Probably
  • No way
  • Too early to say

Stocks jumped Friday after the Fed made the rare move of cutting its largely symbolic discount rate in a bid to help restore faith in the badly shaken credit markets.

The rally followed Thursday's rollercoaster ride, when the Dow bounced back from a 342-point drop to close down just 15 points - but only after the market fell far enough to get near a "correction" of 10 percent from the highs hit just last month.

Although the Fed didn't cut its more closely tracked federal funds rate, which affects consumer loans, the nation's central bank did cut the discount rate - which affects banks and other lenders. (Full story)

The move was important symbolically, showing that the Fed is aware that the subprime lending crisis has shaken financial market confidence over the summer. It was also significant, analysts said, in that it could egg on banks who were previously too wary to lend money. This in turn could help a variety of financial stocks and by turn, the broader market.

But what the Fed move probably won't do, analysts say, is end the day-to-day seesawing that's been the stock market's MO during this unusually busy summer on Wall Street.

"You've gone from complete despair and pessimism on the part of investors to a calming but still very fluid and volatile period ahead," said Ned Riley, chief investment strategist at Riley Asset Management.

Volatility probably won't disappear because the problems with the mortgage and credit markets aren't going to go away, said Ben Halliburton, chief investment officer and founder at Tradition Capital Management.

"You're going to see more hedge fund problems, more funds withdrawing money and hedge funds getting shuttered," Halliburton said. "Stock volatility will likely remain high through year-end."

The Fed's move Friday is a help but a temporary one, the analysts say.

"It's a Band-Aid on a gunshot wound," said Chris Johnson, chief investment officer at Johnson Research Group.

The impact of tightening credit after a period of great liquidity has roiled markets all summer, coming after the housing market collapse and fallout from problems in the subprime mortgage market - loans made to consumers with bad credit.

A variety of mortgage lenders - including Countrywide Financial (Charts, Fortune 500) most recently - have suffered dramatic financial setbacks, while investment banks such as Goldman Sachs (Charts, Fortune 500) and BNP Paribas have had to freeze withdrawals from certain funds because of deteriorating market conditions.

The fallout has sent stock markets around the globe falling and spurred central banks worldwide to infuse billions into their banking systems. In light of the ongoing worries, Friday's discount rate cut and a cut in the fed funds rate next month are unlikely to reverse the ongoing problems in the markets.

"The bottom line is the credit situation, the subprime situation, and the confluence of all these items runs a lot deeper through the Street than a Fed move or even a Fed rate cut can fix," Johnson said.

The move soothes some of the nerves in the debt market for the time being, but to think longer-term problems have dissipated would be "naive," said Ryan Atkinson, vice president and market analyst at Balestra Capital.

"By lowering the discount rate, the Fed can target those banks that were too worried to lend money," Atkinson said. "That will settle things in the short-run, but won't help the long-term issue."

For stock market participants, the most important takeaway from the Fed move, and especially the statement, is that the bank has changed its emphasis from the last Fed policy meeting Aug. 8, said Riley.

"There was a fear that the Fed was so focused on inflation that it would risk the economy suffering," he said. "So it's encouraging that the bankers acknowledge that the economy is at risk of being undermined by the credit crisis and deterioration in housing."

The acknowledgment gives the bank room to cut rates at the next policy meeting on Sept. 18, something the market would like.

But on the downside, the acknowledgment could also spell bigger problems farther down the road, said Stephen Leeb, president at Leeb Capital Management.

"The statement shows that the Fed doesn't have many tools available to both fight inflation and keep the economy on track and that it's willing to tolerate higher inflation rather than a slowdown in economic growth," Leeb said. "Inflation is going to be a big concern for the markets six or 12 months out."

Leeb said that's because economic growth worldwide continues at a rapid pace, despite recent signs of a U.S. slowdown.

While stocks could rally another day or two, the market is likely to remain volatile through the next Fed meeting and perhaps through the end of the seasonally weak month of September, analysts said. Beyond that, a traditional fourth-quarter rally could follow.

(Why is the fourth-quarter often good to Wall Street? Click here.)

"If there's going to be another wave down, it will happen in the next month or so, but beyond that, it could move higher," said Steven Goldman, market analyst at Weeden & Co. "The seasonal factors come into play in the fourth quarter of the year, which might be a good time for base building."

Leeb said that although stocks may slip back to Thursday's low over the next few months (about 1370 for the S&P 500), stocks likely won't slip much lower.

"I think we saw a bottom yesterday," Leeb said. "You had record volume yesterday and now you have the Fed doing what the market wanted today."

As such, it's reasonable to suggest that the major gauges could end the year at or just above the 2007 highs hit in mid-July, the analysts said.

That's assuming that the Fed follows through on the implications of Friday's cut by cutting the more influential fed funds rate at the September meeting.

Fed funds futures on the Chicago Board of Trade show investors betting the Fed will cut rates by at least a quarter-percentage point in September. The fed funds rate currently stands at 5.25 percent, where the central bank has held it since August 2006, after raising rates 17 times in a row starting in 2004.

But if the Fed doesn't follow through by cutting the fed funds rate at the next meeting, stock markets would probably be very disappointed, analysts said. That could spark another leg down.

"A rate cut at this point seems to be a necessary evil for the stock market," Riley said. Top of page