Pullback Prediction: Why Stocks Are Falling

The worst of the recession is likely over, but our pundits spent the last week looking at factors that stand in the way of a robust recovery -- and could ultimately lead to a market correction. They kept a close eye on the unrest in Iran, the dollar, unemployment, rising bond yields, weak corporate profits and updates on government spending policies. Inflation, in particular, weighed on their minds. And as the market opened Monday it looked as though some of their concerns were actually coming to fruition. The Dow Jones Industrial Average dropped almost 200 points during early trading. 

"Market participants’ concerns are shifting from a potential lengthening and deepening of the recession to the inflation that might be stoked by a recovery," wrote Jeffrey Kleintop, chief market strategist at LPL Financial. "In the past, high and rising inflation has proven to be a far harder problem to solve than a weakening economy in recession."

Before Monday none of our pundits' concerns had stopped the stock market from continuing a run that began in early March. Indeed, the major indexes either got near or surpassed their yearly highs last week. Friday a decent consumer sentiment reading and news some financial firms could start paying back TARP funds as early as Wednesday put the Dow Jones Industrial at 8799 when the closing bell rang. That level is slightly above where it started 2009.

That said, most market watchers believe Monday's pullback was long overdue. As the week got started a strenghtening dollar, a sell off in commodities, Iran and general profit-taking sent stocks lower. "Our approach to timing the pullback is to watch for breakdowns in asset class and equity market correlations," wrote Barry Knapp, portfolio strategist at Barclays Capital. "In other words, we are looking for the point when massive monetary stimulus is no longer lifting all asset classes, regardless of core fundamentals and valuation."

For market watchers buying into the pullback theory, one data point getting a lot of attention is the rising yield on a 10-year Treasury bond, which has soared to a high not seen since November. That increase has pushed mortgage rates up and slowed new loans -- two things that could derail any housing rebound. Ed Yardeni, founder of Yardeni Research, calls investors doing this "Bond Vigilantes." He says: "Bond Vigilantes have effectively checkmated any further expansion of the Fed's March 18 quantitative easing policy" of pumping money into the economy.

Unemployment is another closely watched data point. Last week a government report showed there were 345,000 job cuts in May, a little better than expected. But our pundits cautioned there are still six million people out of work and the national unemployment rate is 9.4%.

If consumers don't have a strong sense of job security they cut back on spending. And that hampers the ability of corporations to grow their businesses. Donald Ratajczak, an economist with Morgan Keegan, wrote Friday that consumers are still shifting from spending to saving. That's led to a dropoff in business shipments.

Market watchers say any sustained recovery can only be built on profits -- and stock prices that increase on fundamentals not speculation. "In other words, the forward earnings recovery is looking more L-shaped than V-shaped so far," says Yardeni, referring to a rebound that will be flat and slow vs. one that will pick up fast.

Just as recessions don't happen overnight, recoveries take time, and while investors want a clear story line, the depth of this crisis makes one elusive.