NEW YORK The stock market has been put on notice by the Federal Reserve: from here on in, you're on your own.
Stock markets worldwide have fallen sharply since comments on Wednesday by Fed Chairman Ben Bernanke laying out the U.S. central bank's plans to pull back on its $85 billion in monthly asset purchases. U.S. stocks endured their worst two-day selloff since November 2011, and the Dow Jones industrials fell 354 points on Thursday. .N
The declines, should they continue, would justify the fears of those who believed the rally that sent the S&P 500 .SPX to record highs last month was only due to Fed intervention.
"We are going to continue to see volatility until we get to a point where the markets come to terms with the fact that we have a sustainable recovery in our hands, that it is not in need of life support," said Peter Kenny, chief market strategist at Knight Capital in Jersey City, New Jersey.
Even though the move theoretically means market fundamentals will rise in importance, the selloff shows the process is going to be a tricky one for traders and investors to navigate as they encounter economic data likely to give off contradictory signals.
ADJUSTING TO REALITY
Many expect wild swings in the coming months as the market adjusts to this new reality. Investors are likely to worry that surprisingly strong economic figures will hasten the Fed's exit from markets - ironically putting the market in the position of rooting for good-but-not-great economic figures.
Just the same, if the Fed is bent on reducing its bond-buying program absent a calamity, signs of mediocre economic growth won't inspire buying, either.
So far this year "it was a matter of 'good data is good and bad data is good,'" said Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds Management in Menomonee Falls, Wisconsin.
"You can't take bad data any more as an excuse for a rally in the market," he said.
Investors are almost evenly split on whether the Federal Reserve will be able to manage the transition to higher interest rates without doing serious harm to the economy, according to the Wells Fargo/Gallup Investor and Retirement Optimism Index, released on Thursday. Forty-six percent of those surveyed said the Fed will be successful, while 43 percent said the economy will suffer great harm when policy changes.
Market participants are struggling with this right now. The CBOE Volatility Index .VIX, a gauge of anxiety on Wall Street, jumped 23 percent on Thursday to 20.49, the first time this year it has exceeded 20, an often-used line of demarcation between calm and stressed markets.
Along with the VIX, there were other indicators showing increased concern about declines. The S&P's one-month "skew," which measures the difference between buying downside put options and upside call options, surged to a one-year high, according to Credit Suisse. That means downside protection has gotten very expensive.
In addition, on a day when less than 5 percent of the S&P 500's components ended higher, shares of CME Group (CME.O) hit a 52-week high in a sign investors expect trading in derivatives to rise as traders protect against losses. More than 20 million options contracts traded on Wednesday, according to OCC, formerly Options Clearing Corp, the busiest day since May 22.
LOOKING AT VALUATION
For some, the selling is not justified, as Bernanke made it that clear that only when the economy is healthy enough to thrive on its own will the Fed take away "the punchbowl," - a reference to the statement by former Fed Chairman William McChesney Martin that the Fed's job is "to take away the punch bowl just as the party gets going."
In addition, for all of the recent volatility, the U.S. markets have been a relative oasis compared with stock markets around the world, which have been hit harder since Ben Bernanke first broached the reduction of stimulus on May 22.
Japan's Nikkei 225 .N225 has lost nearly 17 percent since May 21; Brazil's Bovespa .BVSP is down 15 percent in that time, and the MSCI All-World Index .MIWD00000PUS has lost 7.1 percent. The S&P is down just 4.9 percent, a signal that investors believe the U.S. outlook is stronger.
"If you look at the fundamentals of U.S. equities, not only in a stand-alone basis but relative to the rest of the world, in both those categories it is really hard to find a more attractive asset right now than U.S. equities," said Stephen Sachs, head of capital markets at ProShares in Bethesda, Maryland.
That thesis will be tested as the summer wears on, and as earnings season approaches. The relatively attractive valuations currently seen in markets have to take into account low borrowing costs that have helped companies secure cheap funding.
With the back-up in Treasury yields, the 10-year Treasury rate at 2.42 percent is more attractive than the S&P 500's dividend yield of 2.13 percent, notes Andrew Wilkinson, chief economic strategist at Miller Tabak. That could portend more selling in stocks.
Still, at 14.4, the forward price to earnings ratio of the S&P 500 is slightly below the historic norm. A pullback could be a shallow one if valuations become more attractive, depending on the corporate earnings outlook.
"There has to be a rotation towards more compelling, compressed valuations," said Knight's Kenny. "That should be welcome, but that doesn't mean it's going to feel good."