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Stocks Slide, Volatility Spikes: Is Market Overreacting to Fed?

Breakout

After seven months of uninterrupted gains for the major stock indexes, volatility (^VIX) has come back with a vengeance. In two short days, the S&P 500 (^GSPC) has slipped to a two-week low and is now about 5% below its all-time high set a month ago.

At the same time, the yield on the 10-year Treasury (^TNX) is cruising towards a 2.5% print for the first time in two years, while rate-sensitive sectors like Utilities (XLU) and Real Estate (^RMZ) are already in correction-mode (e.g. down 10 percent or more from the 52-week high) and halfway to full fledged bear market (e.g. a decline of 20 percent or more).

The reason why all of these horrible things are happening is because Ben Bernanke and the Fed think that the risks to the economy have diminished.

"This feels like an overreaction. The Fed didn't tell us anything we didn't already know," says Jeff Kleintop, chief market strategist at LPL Financial, in the attached video. "It's hard not to cheer for the unemployment rate getting down to 7% (from the current 7.6%)."

While he is predicting a prolonged period of volatility will be with us, he is not expecting a complete washout in U.S. stocks. Bonds however, could prove to be more vulnerable and he says the sell-off in Treasuries and other fixed income investments could continue a bit longer.

If it does, and the prospect (and reality) of rising rates doesn't stabilize or even reverse as experts like Bill Gross have predicted, than it could get ugly for stocks.

"The risk is if rising rates start to negatively impact the housing picture," Kleintop cautions, pointing out the broader implications for the markets and the economy if we were to suddenly lose momentum in what he says has been "a linchpin of the recovery."

Adding to angst is the fact that global markets, particularly Emerging markets (EEM), don't look to be picking up any of the slack. While China, for example, used to serve as a counter-weight to recessionary conditions in most of Europe, the Asian giant has just printed a second month of slowing manufacturing data that suggests contraction rather than any growth at all.

While the effects of this budding transition play out, Kleintop recommends that investors ''use this opportunity to build back (underweighted) equity positions," but also to look for rising dollar plays, bond market alternatives and heightened volatility (^VIX).

"We may see stocks move another 5% higher or so through year-end," he says, "but believe me, it's going to come with a lot of these ups and downs."

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