THIS WEEK IN THE MARKETS

It was quite a volatile week for the markets with earnings being the primary focus.  There were, of course a couple of other 'earth-moving' events.  Tuesday marked the last meeting for Fed Chairman Alan Greenspan, who bid adieu after a long tenure as the head banker...and gave the markets another rate hike.  On this same day, President Bush addressed the nation in his annual State of the Union speech.  Fresh new terror threats along with oil reaching new heights troubled the indices.  But make no mistake...the market is headed for some troubled waters ahead.  From a technical perspective, breadth was polar opposite from the previous week, which points to further weakness ahead.  Solid price support levels were violated on a close Friday, with the most meaningful of all being the 50 day moving average on most indices.  Gold rose sharply early in the week on terrorist fears, but backed off as the dollar rose following Tuesday's rate hike.  Interest rates continue to confound, as we now find ourselves in an inverted curve situation.  The media will spin this data every which way, but suffice to say this is NOT a positive for the markets...it's quite a negative!  The earnings picture has been moderate, at best...with guidance being the clear disappointment.  Inflation fears were fanned with Friday's employment report...which spooked some into believing the Fed was not nearly done in their rate hike adjustments. 

WE'RE ALL FED UP!

This week, we'll take a brief look at the Federal Reserve and why their actions have such a profound affect on the markets, and why it seems market players are so paranoid when they move rates.  Basically, the Federal Reserve's job is to maintain price stability in markets, to add/subtract money supply from the financial system in order to keep the balance of risks in check.  Also, they tend to serve as an 'inflation fighter' in keeping prices stable.  Our markets generally ebb and flow with the money supply...running higher with a flow of funds, retreating with a retracement of funds.  This puts a major amount of control in the hands of the Federal Reserve.  The money supply is the lifeblood of our financial markets.  We know that prices reach higher with greater demand, and investors/traders vote their dollars each day by making purchases.  With more buying power, prices can rise higher..until the gravy train is slowed or halted.  Pretty scary thought, huh?  It isn't quite that simple, however.  The Federal Reserve is not ACTUALLY making direct investments in the markets..but will limit reserve requirements by banks...allowing these institutions to add flows into the financial markets.  Rising interest rates force investors in longer term instruments (bonds) to sell and buy the newer paper at higher rates...creating supply issues, dropping prices, and increasing yield.  Bond players are the most paranoid, reacting in lock-step with the Fed at each movement. 

Why should the stock market be concerned with fluctuating interest rates.  Simply put, rate moves change the cost of financing a business.  Sure, equity is a form of financing....usually the most expensive of all.  However, the bond market offers an alternative financing need for a business, a lower cost than equity...but a debt obligation.  With higher rates, the cost of this financing rises...and the earnings hurdle rate can be substantially higher.  Basically, higher interest rates increase the cost of doing business, while lower rates have the opposite affect.  Higher interest costs mean less drops to the bottomline, hence...lower earnings.   As traders, we can't really focus on the day to day fluctations in rates...it's difficult to measure the daily impact.  However, we should be mindful of trends in this area...to stay ahead of the curve.  The public is generally the last to notice the winds of change.

Price Headley is the founder and chief analyst of BigTrends.com.