Market Week: A Big Lift, or a Sign of Trouble?

TRADERS were ecstatic when the Federal Reserve cut interest rates by half a percentage point instead of the quarter-point move that many had expected. Whether the good times keep rolling or slow to a crawl as second thoughts emerge may become clear this week.

This week: The thinking behind the Fed's interest rate cuts, E*Trade's subprime mortgage exposure, a Russian financier's New York hedge fund operations, and a warning about earnings manipulation.

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It could go either way, said Ed Yardeni, president of Yardeni Research. It depends on how much largess Wall Street is counting on from the central bank, and for how long.

“Markets look for something to worry about,” he noted. “There could be anxiety over higher inflation and the Fed taking back what it just gave us” by raising rates at some point. If a more benign view takes hold, he said, “getting back to all-time highs by year-end is also possible.”

Mr. Yardeni agreed with the market’s verdict on the Fed’s move, but he suggested that the big rate cut was a sign of a big underlying problem.

“There are so many linkages between global capital markets and the global economy that if the financial markets continue to remain in a chaotic state, it could cause not just a modest recession but a very severe one,” he said. The easing of rates and huge injections of money into the system by the Fed and its counterparts in Europe and Britain are “clearly related to the worst-case scenario being viewed as a big possibility.”

Mr. Yardeni will scour the next few days of market action for hints that the rally in stocks is the start of something grander and more persistent or just an eye-popping fake-out. A main sector to watch, in his view, is financial services.

If the advance last week “is a precursor of a broadening rally in the stock market, that would be great news,” he said. “If it becomes narrower and narrower and we lose financials again, it would be something to worry about.”

If share prices continue higher, “it will suggest that investors believe this action will avert a recession and sustain global economic growth,” he added. “That can create its own magic through a very positive wealth effect” as swelling portfolios encourage investors to spend more.

But it will not be an easy feat to pull off, he cautioned. “My thinking,” he said, “is that the market is going to recognize that this isn’t going to completely turn housing around and that the domestic economy is going to remain subpar.”

DATA WATCH No positive wealth effect is expected in the August housing reports that are due this week. A Bloomberg News poll of economists predicts a decline in sales of existing homes, to an annual rate of 5.5 million units from 5.75 million in July; that report will be on Tuesday. On Thursday, new-home sales are forecast to show a decline to an 830,000 annual rate, from 870,000.