The Federal Reserve holds the wild card for the U.S. stock market next week.
Will the U.S. central bank now slow the pace of its stimulative bond buying as the economy's outlook begins to brighten or will it wait, setting the stage for stock investors' undreamed of gains to keep going?
Fed policymakers gather for the last time in 2013 for a two-day meeting that concludes on Wednesday. Many investors are still expecting the Fed to delay scaling back its $85-billion-a-month bond buying program until early next year. But recent developments suggest a December move by the Fed is at least in the realm of possibilities. Those developments include a stronger-than-expected November jobs report, a U.S. budget deal in Washington and the latest signs of tame inflation.
A decision to begin scaling back quantitative easing now is "potentially the largest factor for the market in the near term," said Robert McIver, co-portfolio manager of the Jensen Quality Growth Fund in Lake Oswego, Oregon. "The very thought of it has had a very negative reaction in the market," so a period of consolidation is likely to follow, he said.
Indeed, stocks logged their worst week in nearly four months this week. The Fed's ultra-loose money policy, adopted more than four years ago, has helped lift the Standard & Poor's 500 index 24 percent so far this year. In an effort to promote economic growth, the Fed has been buying Treasuries and mortgage-backed bonds to keep long-term interest rates low.
Stocks temporarily pulled back from their rally this year when Fed Chairman Ben Bernanke began hinting in May that a reduction in the stimulus program may be near.
Stronger Jobs Market
Comments by Fed policymakers this week have leaned toward the central bank being closer to trimming bond purchases. St. Louis Fed President James Bullard, who is a voting member on the Fed's policymaking committee, said the Fed could slightly reduce the purchase program this month after signs of a stronger job market.
Most economists in a Reuters poll this week said they expect Fed policymakers to defer action until January or March, but the number of those expecting a Fed move in December has increased compared with one month ago. Some stock traders, guarding against a Fed surprise, have been using options as a hedge against possible losses.
What the Fed will do is still an open question. The central bank surprised many investors in September when it kept its stimulus in place. The S&P 500 is on track to end 2013 with its best yearly gain since 2003, so what the Fed decides could mean the difference between pulling back or resuming the advance.
"Once we get the Fed news out of the way next week, I expect the seasonal factor to kick in and we may see historical highs again leading up to the new year," said Ryan Detrick, analyst at Schaeffer's Investment Research in Cincinnati, Ohio.
Some analysts argue investors are making too much out of the issue of tapering since the Fed is likely to continue its accommodative measures for many months to come.
Low Rates Promised
Even as it has begun to talk about reducing stimulus, the Fed has vowed to keep interest rates low for a long time, and most Fed officials expect no rate hike until 2015. That means the Fed is likely to be very careful to create a cushion for the economy, as well as the markets, they said.
"I think people are fibrilating about tapering. Every day they're looking for a new speck of information about it," said John Rutledge, chief investment officer of Safanad, a New York-based private investment firm. "I don't think they will announce anything next week, and when they do announce tapering, they will take great pains" to reassure the market.
Several stock market strategists in a Reuters poll released Thursday said they expected any reduction in its bond buying to be a small amount initially. Investors will be keen to hear any comments from the Fed on how long it is likely to keep rates low. Given the amount of talk surrounding a Fed tapering, investors could hardly be in for a punch, analysts said.
"One would expect there would be a knee-jerk reaction," said Eric Kuby, chief investment officer at North Star Investment Management Corp. in Chicago. But, "it would be more of a surprise than a shock."