Wall Street cowers as Fed hints at stimulus pull-back

• Dow plunge Thursday creates biggest two-day drop in 19 months
• Fed%27s optimism about the economy means stimulus might be nearing end
• Even so%2C 10 of 11 past %27tightening periods%27 have seen stocks rise

NEW YORK — Wall Street is undergoing a major bout of turbulence and financial markets are in sell-off mode as investors start coming to grips with the eventual transition to a less market-friendly Federal Reserve.

The mood of financial markets has shifted abruptly from giddy to anxious in a 48-hour span. The swing began Wednesday when Federal Reserve Chairman Ben Bernanke let investors know that if the economy keeps chugging along that it could start pulling back later this year on the massive stimulus that it has been injecting into markets since 2008. The increase in investor skepticism comes despite the fact the Fed upgraded its outlook for the economy and job market.

Investors have not reacted well to the idea that the central bank will be soon providing less, not more, support to the market. Nor have they warmed to the idea that the long period of artificially low interest rates — which have provided a major booster shot to the stock market, economy and housing recovery — might be nearing an end.

The coming shift has turned financial markets upside-down, with stocks, bonds, commodities and virtually every investment suffering sharp declines. The Dow Jones industrial average, which fell 354 points Thursday, has plunged more than 550 points the past two sessions, its biggest two-day drop in 19 months. The Dow is still up 12.6% for the year.

The Standard & Poor's 500 index, a broad market gauge, is down 4.9% from its May 21 all-time high and on the verge of its first 5%-plus drop since November.

U.S. Treasury bonds have also plunged, with yields, which move in the opposite direction, surging to 2.42%, their highest level since August 2011. Gold, copper, zinc have all taken a hit, as have emerging market stocks.

"The worry," says Bruce Bittles, chief investment strategist at R.W. Baird, "is that the Fed is taking away the market's safety net."

The Federal Reserve signaled Wednesday that it may pull back later this year on its massive bond buying that has helped fuel the economy and asset prices. The Fed has been buying $85 billion of mortgage-backed bonds and long-term Treasury bonds, massive buying power that has been described as "steroids" for the market, and which has driven borrowing costs down sharply.

In short, market participants aren't sure the market and economy can stand on its own without help from the Fed. They fear that a sharp rise in interest rates will hurt the economy, corporate earnings and stocks is also palpable.

"The Fed has been a crutch for the market for years," says Frank Fantozzi, CEO of wealth management firm Planned Financial Services. "The fear is that they are pulling the crutch away."

The market's wild ride, however, is not unusual when the Fed starts to hint at, or embark on, a new phase of tighter monetary policy. The knee-jerk reaction of investors is normally to over-react to the shift to a less-easy Fed.

But historical data also shows that the stock market actually goes up during periods of Fed tightening. (It's important to note, though, that the Fed has said that it is unlikely to start raising short-term interest rates, which are now roughly paying 0%, until the unemployment rate, now 7.6%, hits 6.5%. Most Fed members don't see rates rising until 2015.)

In fact, the broad U.S. stock market rose in value during 10 of the past 11 cycles in which the Fed was raising interest rates, according to data from Birinyi Associates. And the average gain for stocks during those "tightening periods" was 9%. History also shows that, on average, bear markets don't strike for at least two years after the Fed starts to hike rates.

Investors, says Kevin Pleines, an analyst at Birinyi, should "pay attention to the Fed ... just don't panic."

Even so, the recent market turbulence could be the start of a price correction of anywhere from 10% to 12%, says Carmine Grigoli, chief investment strategist at Mizuho Securities USA. The fact that the Fed is about to start winding down an "experimental" policy adds an extra element of risk.

"It adds a huge element of uncertainty and that makes investors very nervous," says Grigoli, adding that he would use stock market dips to add to stock positions, as he thinks the economy and corporate earnings are still strong enough to keep the rally going longer term.

Many investors, including Bittles, believe "less Fed intervention with be healthy for the market" longer term.

Thursday, the blue-chip Dow suffered its eighth straight day of triple-digit moves up or down, the longest such streak since a nine-day one in early October 2011.

In many ways, the market is suffering a form of "withdrawal" after years of steroid-like cheap money injected into the system by the Fed.

Says Michael Farr of money management firm Farr, Miller & Washington: "The reaction we're seeing should be expected after five years of dependency on Fed intervention and monetary policy."

U.S. investors are being swept up in a global market adjustment to a period of rising rates, says Doug Sandler of RiverFront Investment Group. Global investors who have used borrowed money to place large and risky bets that are dependent on low interest rates are having these bets go against them, forcing them to sell, he says.

The amount of margin debt, or money borrowed by investors against their portfolios, hit a record $384.4 billion in April, according to the New York Stock Exchange. That borrowed money is often used to invest in stocks and other investments. So a sharp drop in markets often forces these investors to have to sell securities to meet the minimum amount of assets, or collateral, that brokerages require.

The market's volatile and negative reaction to the Fed's hints that the days of market-friendly stimulus are numbered is not unexpected, given that the market is forward-looking and tends to price in events three to six months in the future, says Gary Thayer, chief macro strategist at Wells Fargo Advisors.

The market is undergoing a "change, a shift, a transition," which is causing a repricing of assets, he adds.

"Any sign of a change in policy tends to cause uncertainty," says Thayer, adding that heightened uncertainty often results in a market "overreaction" to new information.

Part of the concern for stock investors is that they don't know how fast or high rates will rise. Higher rates are a negative for stocks because they push up borrowing costs, which is a drag on economic growth and the all-important housing market. A rebound in home sales has been a key driver of the economic recovery.

"There's a (worry) that we have seen the lows in bond yields," Thayer says. "And that prompts investors to ask: 'Where will they go from here?'"

Thayer, though, thinks investors are too unnerved by the Fed's eventual move to tighten monetary policy. "It's human nature," he says.

Thayer argues that the Fed's coming policy shift is good news because it means the economy is strong enough to handle the change.

In government reports out Thursday, existing home sales jumped 4.2% in May and the median price is up 15.4% from a year ago, the government said. A separate report showed weekly jobless claims rose slightly, but the level remains consistent with moderate job growth.

Thayer says the fact that the Fed is considering cutting back now, when inflation is benign, is another positive sign. He says he thinks bond yields will stabilize and stock investors with longer-term horizons will start "looking for values created" by the Fed news. He is sticking with his year-end price target for the S&P 500, which he recently raised to a range of 1,650 to 1,700, or roughly 6% above current levels.

Fantozzi concurs that the bull market can survive the threat of a looming Fed exit. In fact, he was using the lower prices Thursday to buy stocks. "I'm thinking like I got a Kmart Blue Light Special." He says he will be watching to see if other bargain-hunting investors swoop in for values as well. If they do, that could signal the end of the recent pullback.