Wall St.: Thanks, we needed that
The word 'nimble' notwithstanding, the credit for Tuesday and Wednesday's big stock rally also goes to Monday's word of the day: 'correction.'
NEW YORK (CNNMoney.com) -- Yippee! Stocks are up two days in a row. The Fed's going to cut rates. Recession be damned, we're going to be OK.
After all, one need only consider the rock-solid cause of Wednesday's 300-plus point day on the Dow: the word "nimble."
Well, not entirely, but it's the word Federal Reserve Vice Chairman Donald Kohn used in a prepared speech given to the Council on Foreign Relations. He used it to refer to how the Fed might want to approach monetary policy amid the uncertain economic outlook. He also said that the Fed should be "flexible" and "pragmatic."
Stock investors seemed to take this as a sign that the Fed will cut rates by at least a quarter percentage point at the Dec. 11 meeting, which in itself apparently justified Wednesday's advance.
"The key is that Kohn took a more conciliatory tone, that he signaled a change in the recent Fed commentary," said Phil Orlando, chief equity market strategist at Federated Investors. "The thinking here is that the Fed Vice Chairman would not have made his comments without first speaking with Fed Chairman Ben Bernanke, who is speaking tomorrow (Thursday)."
So by extension, the expectation might be that Bernanke is likely to follow up on Kohn's comments with something similar, reassuring investors that the Fed knows that it needs to act and that it will. Bernanke is speaking before the Charlotte, N.C., Chamber of Commerce Thursday night.
Well, Jack be nimble, Jack be quick, cause the word "nimble" apparently cancels out Monday's word of the day: "recession." That word sparked a more than 200-plus point decline on the Dow.
There's no question that when Fed officials speak, particularly those named Bernanke, the stock market listens. And if the cavalry is truly coming, that would be a huge relief to investors who have been wondering if the Fed was slacking a bit, considering the ongoing subprime fallout, near $100-a-barrel oil, a plunging dollar, weak earnings, et cetera.
But it's also no coincidence that all this is happening when the market is in a very volatile period and when it just "corrected" not two days ago.
How volatile? In every trading day in November, the Dow has moved at least 100 points in either direction during the session, regardless of where it ended up closing.
As for the "correction," as of Monday's close, the three major stock gauges had all fallen at least 10 percent from the October highs. And after corrections, big stock swings tend to happen.
"You're at an oversold level and then you get the single-most needed variable - some appreciation from the Fed that the risks to the economy are no longer in balance," Orlando said. "I think you'll see a follow through one way or the other based on Bernanke's comments."
Fed's Kohn says bank needs to be 'nimble'
Sometimes historically, a correction can presage a bear market, defined as a drop of at least 20 percent off the highs, as the initial 10 percent sparks another wave of selling. (See: The bursting of the tech bubble, circa 2000.)
At other times, it can spark a big rally, with investors using the lower levels of the market as an opportunity to switch back into stocks, particularly those that have been beaten down in the selloff.
That's what happened the last time the market officially corrected, in March 2003, at the start of the Iraq war. That correction led to the second leg of the current bull market, 4-1/2 years old and counting.
But the follow-up to a correction is not always so long-lasting. This summer there was a "correction" of sorts, with the S&P 500 falling 10 percent through Aug. 16 at the height of the credit market crisis. The Dow and Nasdaq fell just short of the 10 percent level. But all three snapped back through mid-October as the Fed first hinted and then began cutting rates.
This could be round two.
"If indeed this is the end of the correction, as I think it is, this would be roughly equivalent to what happened this summer," said Katie Townshend, chief market technician at MKM Partners. "I think we could get back to new highs again before the end of the year."
She said that a variety of technical factors she looks at show that the market was getting very "oversold," including how bearish investors were getting at the end of last week. Going into Wednesday morning, 40 percent of the S&P 500 components showed that they were oversold on a short and long-term basis.
All of which suggests that, technically, the market was primed for a fiery gain, and Kohn may have been the kindling.
Other pluses: November and December are traditionally strong seasonally, even if that hasn't been the case this year so far. Additionally, the two months tend to be strong going into a presidential election year, she said. So the seasonal factors could play in.
Other evidence of a post-correction bounce can be found in the specifics of which stocks are leading the advance.
Monday's steep selloff brought more punishment for some of the year's worst performers, including homebuilders, down 68 percent, and thrifts and mortgage lenders, down 58 percent. And Wednesday's biggest gainers? Yep, homebuilders, and thrifts and mortgage lenders.
The broader financial sector is up nearly 6 percent Wednesday, as demonstrated by the Amex Securities Broker/Dealer index. Year-to-date, financial is also the biggest loser of the 10 sectors tracked by Standard and Poor's, down 21.7 percent as of Tuesday's close.
Townshend said that the sectors that have gotten beaten up the worst - such as financial, homebuilders and retail - are only due for a short-term bounce. But that bounce could be significant for the broader market longer term, in that it could restore confidence that then causes buying in other areas.
Yet, the technical momentum would be challenged longer term if Kohn's comments were just there to cool worries and not really signal a bigger change in the Fed's outlook and plans. Or the momentum could be challenged if the Fed does start cutting more aggressively, but a recession rolls in regardless.