U.S. stocks could be set for another selloff next week as the Federal Reserve is expected to announce it will keep withdrawing its economic stimulus, further pressuring equities already roiled by a flight from emerging markets.
Investor sentiment turned strongly bearish this week as emerging markets were hit by both country-specific problems and the realization that the Fed's trimmed bond-buying program reduces the liquidity that has boosted higher-yielding emerging market assets and put a floor under U.S. stock prices.
The Fed's plan to gradually withdraw its stimulus has long been expected to lead to a pullout from emerging markets. But the prospect of an economic slowdown in China added to concerns on Friday that emerging markets, particularly those with large current account deficits, may struggle to support their currencies this year.
The Fed's policy-setting committee meets on Tuesday and Wednesday. Another cut to the monthly purchase of Treasuries and mortgage-backed securities - to $65 billion from the current $75 billion - is all but certain, based on policymakers' recent comments.
"Is the Fed going to zigzag with the taper, based on what we already knew, that emerging markets were vulnerable to liquidity being taken out of the system in the U.S." said Quincy Krosby, market strategist at Prudential Financial in Newark.
"It's a moral hazard," she said, adding that regardless of when the Fed withdraws further, the expected market reaction will be roughly the same.
The broad selloff in emerging markets over the past two sessions translated into the worst week for global stocks in seven months. The S&P 500 slid 2.6 percent, its largest weekly decline since June 2012.
It would be hard, however, for the Fed to skip a taper, citing a pullback in the stock market, when the S&P 500 is just 3.1 percent below its record closing high, set last week.
SOME SEE 'BUY' SIGNS
Economic data next week, including new home sales and consumer confidence, is expected to continue to paint a picture of recovery in the U.S. economy, which could help bring buyers back into U.S. equities.
"There are good domestic reasons to expect the U.S. economy to be doing well over the year to come, and our central expectation is that while U.S. markets could take a temporary hit (due to the selloff in emerging markets), the shock will not be a major one for the U.S. economy," Deutsche Bank analysts wrote in a note released on Friday.
The Fed's promise to keep interest rates near zero for an extended period could also help bring back buyers. The question for investors is: How far will the market pull back before cash flows back in
"Ultimately, it's going to be a buying opportunity," Krosby said. "The market needs to figure out how much of the move has been liquidity driven and what was based on earnings."
The technical picture deteriorated somewhat as the S&P 500 closed below its 50-day moving average for the first time since early October. But this week's selloff also brought momentum indicators down from overbought levels.
In a signal that the selling on Wall Street may be overextended, investors were willing to pay more for spot protection against a drop in the S&P 500 than three months down the road.
The last time the spread between the CBOE Volatility Index and three-month VIX futures turned negative was in mid-October, shortly after a 4.8 percent pullback in the S&P 500 opened the door to the last leg of the 2013 market rally.
APPLE EARNINGS TO START THE WEEK
Aside from the Fed and economic data, traders will also face next week's flood of earnings, including results from Dow components Caterpillar, DuPont, Pfizer, AT&T and 3M.
Technology giants like Google and Facebook will also post quarterly scorecards. Apple, the largest U.S. company by market capitalization, will set the stage after the closing bell on Monday.
"Earnings have not been as stellar as everyone is making them out to be. You see massive stock buybacks, which have given that impression," said Ken Polcari, director of the NYSE floor division at O'Neil Securities in New York.
"Revenues are flat to down - not a good sign. At this point in the cycle, people want to see revenues up."
With about a fourth of the S&P 500 components having reported earnings so far, 63.9 percent have beaten analysts' expectations. Over the past four quarters, 67 percent of companies have exceeded bottom-line estimates.