Why Stocks Are Continuing to Tumble

Blue-chip stocks are continuing their descent today as investors and analysts fruitlessly insist on speculating about the Federal Reserve's next moves. With roughly an hour left in the trading session, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) is off by 41 points, or 0.27%.

The original impetus for today's double-digit decline wasn't something that happened overnight -- though the steep decline in Asian markets certainly didn't help. Rather, it was comments made by Federal Reserve Chairman Ben Bernanke back on May 22 about the possibility that the central bank may reduce its support for the economy. If unemployment and economic growth continue to improve, Bernanke told Congress' Joint Economic Committee, then the bank could decide to reduce its monthly bond purchases at one of its upcoming monetary-policy meetings.

These comments were underscored last week. Following the most recent policy meeting, Bernanke noted, "If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year." Not content to leave it at that, he went on to say, "If the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year."

As I've discussed before, this is big news. While investors should be primarily concerned with the fundamentals of their specific investments (valuation, earnings growth, etc.), the past month has shown that issues of liquidity are important, too. That being said, I continue to believe that investors would generally be best-served by focusingonly on fundamentals. By "liquidity," I mean the Fed's injection of money into the market through its monthly bond purchases. Because this drives down bond yields, investors hunting for income transitioned into stocks over the past year or so. But with these programs purportedly coming to a conclusion, the flow of funds appears to have reversed.

The front lines of this battle are in the housing and banking sectors. The KBW Bank Index (DJINDICES: ^BKX  ) , which tracks the banking sector, is down by 1% as I write. Banks are affected because they hold massive bond portfolios, the value of which will decline as the Fed draws back. At the same time, the resulting higher long-term interest rates (bond prices and yields are inversely correlated) will drive up profitability. At a recent industry conference, Bank of America's chief financial officer addressed the latter issue, saying that if longer-dated yields rose by a percentage point , it would bolster net interest income by about $1.6 billion, according to The Wall Street Journal. And a "parallel shift" -- in which both short- and long-term rates rise by comparable magnitudes -- could yield an additional $3.7 billion.

Meanwhile, housing is feeling the effects via higher mortgage rates. For portions of last year, a 30-year conventional mortgage carried an interest rate of less than 3.5%. Since the Fed's announcements, the same rate has climbed back to more than 4%. This is sending shivers through homebuilders' stocks, as the net effect is to make homes more expensive. The SPDR S&P Homebuilders (NYSEMKT: XHB  ) ETF, which tracks the housing sector, is down almost 9% since May 22.


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