Volatility Takes Center Stage; Are Rising Interest Rates, Inflation Fears, High Oil Prices and the Twin Deficits Finally Just Too Much for the Market to Take? or Will a Traditional Seasonal Trend Play out with a Fourth-Quarter Rally Saving the Day? While Analysts' Forecasts Differ, They Agree on What Traders Should Prepare For: Volatility and More Volatility

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In this midterm presidential election year, one thing rings loud and clear for the stock market: The Federal Reserve is in the driver's seat. In early May the stock market was humming along, but by midmonth the market lost almost all of its gains for the year in a matter of weeks. More corrections followed.

For months the market has gyrated around anticipated interest rate increases and actual rate hikes. Federal Reserve Chairman Ben Bernanke and the Fed moved forward with their inflation fighting campaign and raised the fed funds rate by 25-basis points to 5.25% on June 29, the 17th consecutive rate hike increase in two years. Stocks dived down more than 120 points the day before as investors bailed out ahead of the rate hike. While the phrase "the committee judges that some further tightening may be needed" was not present in the Fed's remarks in June, the comment "the committee judges that some inflation risks remain" stayed.

"The Fed will probably raise rates two or more times," said Stewart DeSoto, president of DeSoto Capital Management, the week before the June hike. "I expect to see the Fed funds rate go up to 6%," adding that the Fed should not have indicated earlier in the year that it was nearly done with its rate tightening. Some analysts even openly blame the stock market's recent weakness on this inconsistency from the Fed.

But while inflation still appeared to be on the mind of Bernanke and Fed policymakers in June, some analysts such as Marc Borghans, chief equity strategist with LaSalle Bank Wealth Management Group, are not very worried about inflation. Commenting on the long term state of inflation Borghans says, "Inflation is not a runaway problem. Chairman Bernanke has to establish his inflation fighting credibility. He needs to give the message that he is serious about this." He adds that while the Fed says it is data dependent, when it comes to rate hike decisions, they seem to not be giving the same weight to data pointing to a slow down in the economy. "But in the end inflation will not be a big problem. You have to understand that inflation is a lagging indicator, not a leading indicator," he says.


According to analysts and the Fed, the housing market will continue to be a major determining factor in where short term interest rates are headed, and as a result where the stock market is going. The National Association of Realtors reported that sales of previously owned homes in the United States fell in May to an annual rate of 6.67 million; the slowest in four months. Borghans says further proof of the market cooling can be found in the owners equivalent rent component of the CPI index. He explains that recently, as the housing market has faded, more people are renting and as a result rents are increasing. "The slightly positive rate of housing growth is fading quickly. It is slowing to a point of being virtually flat. In the coming months I see the rate of growth near flat and that we possibly could have a flat market for a few years."

Mike Kimbarovsky, a principal of the fund of funds Advocate Asset Management, says even a slowdown in the housing market could spell trouble for the stock market. "The nature of the mortgage debt, coupled with rising unsold home inventory makes us pessimistic ... The detrimental results can easily be realized if housing prices simply stopped rising with the same vigor as they have in the past," states Advocate's first quarter market commentary.

A cooling housing market is only part of Kimbarovsky's concerns. His bearish outlook on the market stems from several factors, including that the "U.S. economy is living on borrowed time." Kimbarovsky explains that both consumers and the government's tendency to live in the moment will not bode well for stocks in the long run. America's huge budget deficit, a rising trade deficit and consumers continuing to borrow variable debt serve as drivers for the market to go down. …