Stocks: Stuck in the Twilight Zone

In a market where hopes for a government-led recovery are countered by fears of worsening earnings and economic data, what could finally free stocks to soar—or tumble further?
It's not as if the market is acting calm or boring. Stocks, and especially particular stocks and sectors, can bounce wildly from day to day. But the bouncing hasn't really gotten equities anywhere. Standard & Poor's equity strategist Alec Young noted Jan. 29 that stocks are "boxed into a near-term trading range." Despite several attempts, the broad S&P 500 index can't seem to dip below 740 to 800, while it can't rise above 940 to 1,045.

A deteriorating economy and terrible corporate earnings have stopped any major rallies in their tracks. But hopes for a new Presidential Administration and for an economic recovery in the second half of 2009 have kept stocks from sinking lower.

Rates at Near Zero
So far, the federal government has provided investors with some downside protection. "Anytime there is a move from Washington, the market moves up," says Quincy Krosby, chief investment strategist at the Hartford (HIG). "Then, the gains quickly evaporate."

The Federal Reserve has slashed interest rates to near zero and the Fed's monetary committee said Jan. 28 it may buy long-term U.S. Treasuries to help heal credit markets. The U.S. Congress continues to weigh a large economic stimulus package, with the House of Representatives approving its $825 billion version of the plan Jan. 28. The Obama Administration, meanwhile, is reportedly studying the idea of a new Federal Deposit Insurance Corp.-managed "bad bank" that would buy up toxic assets from financial institutions.

Demonstrating the hopes many market participants put in the government, PIMCO bond fund manager Bill Gross offered his own prescription in his monthly note on the firm's Web site, published Jan. 29. He said the government needs to find ways to support the prices of assets like municipal bonds or commercial mortgage-backed securities.

The Wisdom of Bill Gross
At a time like this, "the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices," Gross writes in his February outlook.

But while government help can spark optimism in the market, those gains can fade quickly. The problem is that many of the government's most important plans are still being developed. The measures that have already been implemented—such as low interest rates or last year's financial bailout—haven't yet stabilized the economy or financial system. "We need to see it happen," says Uri Landesman, head of global growth at ING Investment Management (ING). "It's one thing to debate a bill in Washington and another to see it put in action."

Moreover, many of the measures being debated are unprecedented. No one knows if they will work. "There's no proof in the pudding," says Richard Sparks of Schaeffer's Investment Research. Without knowing if these measures will be successful, investors are stuck merely hoping for a recovery.