Why This Market Ought to Worry Short-Term "Investors"

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

U.S. stocks fell for the second straight day today, with the S&P 500 (SNPINDEX: ^GSPC  ) down 0.57%, while the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) lost 0.60%. Amazingly, that is the S&P 500's largest decline since June 24, which gives you some idea of the relentlessness of the current stock market rally.

Today's losses were enough to see the CBOE Volatility Index (VIX) (VOLATILITYINDICES: ^VIX  ) , Wall Street's "fear index," bounce 7% from yesterday's closing value of 11.84, which was a three-plus-month low and well into the bottom 10% of all closing values. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

It's the Fed ... again
What was behind today's losses? Reuters was willing to offer an explanation: According to the news agency, the negative sentiment reflected two sets of comments by Federal Reserve Bank governors regarding the timetable for a pullback in the Fed's bond-buying program, a.k.a. "quantitative easing."

First, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said the Fed might begin reducing the size of its monthly purchases as early as September, before winding down the program in the medium term -- assuming growth and job creation accelerates in the second half of the year.

Later, Charles Evans, the president of the Chicago Fed, gave reporters his forecast for the second half of the year, in which he expects growth to accelerate to 2.5% from 1% over the past three quarters, before exceeding in 2014. Under those assumptions, Evans said the Fed is "quite likely" to reduce its $85 billion monthly bond purchases "starting later this year."

Is the market really a learning machine?
Two remarks here.

First, the statements of both Fed bank presidents are entirely consistent with the Federal Open Market Committee's July monetary policy statement, which was released last Wednesday.

Second, both men were careful to specify that any tapering in bond purchases is dependent on economic data. Furthermore, the hypothetical calendars they put forward actually require an improvement in economic fundamentals, rather than just a continuation of the status quo.

While I don't normally put too much weight on any attempt to explain the market's daily gyrations, I think Reuters' explanation is plausible. More, it's consistent with the market's overreaction when the notion of a Fed tapering emerged in May and June. Unfortunately, it suggests that the market hasn't learned much since then (despite the Fed's going to great lengths to explain its thinking) and that market sentiment is wedded to the Fed's unconventional policies – even the slightest hint that the Fed will withdraw its dowry is enough to rattle the market.

This is disturbing, since it hints at a stock market stuffed with participants who are unconcerned with underlying fundamentals. For long-term, fundamental investors, that needn't be a worry -- indeed, it can be a source of opportunity.

However, all market participants should be aware that, no matter the lengths the Fed goes to in order to communicate its policy path, this market will remain highly susceptible to bouts of volatility because it is untethered from its fundamentals. The VIX may be at the low end of its historical range, but don't let that fool you. Volatility can -- indeed, will -- pick up unexpectedly in the future.

One way to hedge yourself in case the economic recovery the Fed is looking for doesn't materialize in the U.S. is to own the shares of companies with significant exposure to higher-growth regions. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!


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