Stock market turns risky after Fed’s decision not to taper

Last weeks Wednesday the Dow Jones Industrial Average jumped 147 points Wednesday, returning to record territory after the Fed put off cuts decision. But it gave it all back on Thursday and Friday, falling 226 points and finishing the week at 15451.09, 1.4% off Wednesday’s record.

For now, the Fed continues pumping a full amount of $85 billion a month into bond markets, more than was expected. Analysts thought the market would welcome the decision as a softening of Fed policy, an effort by the Fed to make the stimulus cuts slow and gentle. The market’s negative response to that olive branch suggests that when the Fed does start unwinding financial stimulus in the coming months, markets could face a difficult transition.

“The Fed has changed its tune and the market isnt responding, which bothers me,” said Henry Herrmann, chief executive officer at asset-management firm Waddell & Reed Financial.

The S&P 500 stock index fell 16.8% between July 22, 2011, when talks on a broad deal faltered, and Aug. 8, the first trading day after the government’s AAA debt was downgraded. Every stock in the S&P 500 Index fell on Aug. 8. The index rebounded by about 12% by the end of the year.

Three events would be on focus before the Fed’s next policy meeting, scheduled for Oct. 29 and 30. September job-creation numbers are due Oct. 4. After that, major corporations will begin releasing third-quarter earnings; investors fret those could be soft.

The highly experienced stock analyst Ned Davis, founder of Ned Davis Research, last week shifted to a neutral trading strategy, meaning less stock exposure. With bonds looking weak, he still favors stocks as long-term investments. But he said he saw signs of excessive optimism about stocks. Individual investors have turned more bullish, surveys show. And traders arent using options as much to protect themselves from declines, a sign of overconfidence.

Optimists say investors worry too much about stimulus. The economy is growing and inflation is very low, a good backdrop for stocks. Even after the Fed’s bond-buying ends, it plans to keep target interest rates exceptionally low for years.

However, the Fed is preparing to reduce the purchases. Monetary conditions will most likely be tightening. Eventually, history suggests, the tightening will cause a recession and a bear market.