msnbc.com staff and news service reports
updated 11/15/2010 8:27:31 AM ET 2010-11-15T13:27:31

The Fed Rally is over.

The Federal Reserve took the first step in a $600 billion plan to boost the economy Friday. The same day, the Standard & Poor's 500 index tumbled to its worst weekly loss in three months. It wasn't just a coincidence.

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Stock markets are forward looking. Once the Fed began signaling in late August that it had a stimulus plan in the works, investors started to push stock prices higher. But over the past five days, ominous signs emerged about the global economy:

  • Concerned deepened that Ireland's debt crisis would require a bailout by the European Union.
  • European and Asian countries attacked the Fed policy because it is resulting in a falling dollar that will help U.S. exports at their expense. Fears of a global trade war increased when President Barack Obama and U.S. negotiators failed to reach a new trade agreement with South Korea.
  • Technology giant Cisco Systems Inc. cut its revenue forecast for the rest of the year. Cisco is the world's No. 1 maker of computer networking equipment and a bellwether for the technology industry.

"Everybody was focused on the doctor without looking at the patient," said David Rosenberg, chief economist at Gluskin Sheff in Toronto, likening the Fed to a doctor and the economy to its patient. "The patient may be out of the operating room, but it's still in the sick bay."

That leaves the outlook for stocks uncertain. Federal Reserve Chairman Ben Bernanke hinted in an Aug. 27 speech that the central bank would launch a program to buy bonds to pump money into the economy and spur people and businesses to spend. Economists call the tactic quantitative easing. The Standard and Poor's 500 Index closed that day at 1,064. The index then rose nine of the next ten weeks on its way to reaching a high for the year of 1,227 on Nov. 5, capping a 15 percent gain following Bernanke's speech.

But the index closed Friday at 1,199 after tumbling four out of the last five days. It fell 2.2 percent for the week, its biggest weekly drop in three months.

All stock market rallies occasionally slump when traders lock in some of their gains. But the market may not rebound that quickly this time because it was driven largely by expectations that the Fed's quantitative easing policy would jolt the economy. Before Bernanke's speech, the S&P 500 had lost 12 percent since April on concerns about a double-dip recession.

Quincy Krosby, a market strategist for Prudential Financial Inc., says traders are returning to the nuts and bolts of the economy and will focus on unemployment rates and home sales.

"Economic data are going to start to become important again," she says.

The economy will need to improve by the first part of 2011 for stocks to rise much higher, she says. Profit margins of companies in the S&P 500 are already near a record high due mostly to corporate cost cutting. Companies will have to boost revenue next year to beat this year's earnings numbers, and that's going to be hard unless demand improves. To make matters worse, prices for commodities from corn to copper are soaring.

Major Market Indices

Even many of those who expect stocks to move higher over the next year believe economic growth may remain sluggish.

"I doubt that there will be a smooth rise from here on out," says Bill Stone, chief investment strategist at PNC Financial Services Inc. Nevertheless, he thinks the S&P 500 will climb because its price-to-earnings ratio of 15.4 is a good value considering its 2.3 percent dividend yield is higher than many bonds.

Story: This may be week stocks' rally runs out of gas

Another scenario has gone largely ignored: What if the Fed's plan lives up to its promises? The central bank bought its first batch of Treasury bonds on Friday, the first step in its latest stimulus package. In theory, pushing $600 billion into the banking system should ripple across the economy, encouraging banks to lend, companies to invest in equipment and employees and Americans to open up their wallets. Under this scenario, the chain reaction knocks the unemployment rate below the current 9.6 percent, and another stock market rally lifts off.

Economists call the Fed's effort QE2, because it tried something similar in the middle of the financial crisis. Starting in 2007, the Fed bought $1.7 trillion in mostly mortgage bonds from banks, helping stave off a wider banking collapse. Studies show it also pushed mortgage rates to historic lows, though it has not revived the housing market. The Fed expects the much smaller QE2 to end in June.

At that point, if the economy still looks weak, Prudential's Krosby says we'll have a new question to consider: "Will there be a QE3?"

In the meantime, foreign central banks and a group of U.S. economists have called for the Fed to cancel its QE2 program. Ahead of the G-20 summit in Seoul last week, governments including Germany, Brazil and China called the plan wrong-headed and said it risked sparking inflationary pressures in their countries.

Monday, the Wall Street Journal published a letter to Bernanke from a group of influential economists who said the plan should be "reconsidered and discontinued."

"The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment," the letter said.

The Fed responded by saying it is mandated to help promote higher employment and price stability and that its plan reflects those mandates.

"The Federal Reserve is committed to both parts of its dual mandate and will take all measures to keep inflation low and stable as well as promote growth in employment," said the Fed.  

The Associated Press contributed to this report.

Video: CNBC: The Fed begins QE2

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