What Matters to Stocks (Hint: It's Not the Fed)

Wall Street is over a rate cut.

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Yesterday's big rally in stocks left everyone scrambling for a reason behind the record gain, and lots of journalists and analysts wound up giving the credit to the prospect of a half-point rate cut by the Federal Reserve.

Well, today we got it, and stocks sold off. So what happened? The truth is the Fed's decision to cut rates for the second time in a month was already old news to traders. The effective federal funds rate has already fallen below 1 percent several times in recent weeks, so lowering the official target was really just confirming what the market already knows.

So what really matters for stocks today and in the coming weeks?

The Bottom: Are we there?
Not just yet, even after that 889-point rally in the Dow. Credit problems are still plaguing Wall Street, even though we are seeing some modest improvements: Commercial-paper lending is improving and short-term lending is thawing, but this is a process that will take weeks, if not months, to improve substantially. We've pumped in some $3 trillion worth of liquidity from global financial institutions, and it will have an impact—eventually.

As for stocks, they still haven't managed two back-to-back up days since last month, which makes even huge moves in the Dow a bit suspect in terms of their lasting impact. We didn't get it today, and it's clear that equities are still struggling even after the occasional record-breaking bounce like the one we saw yesterday. "That was a bottom—not the bottom—for this bear market," according to Peter Boockvar, an equity strategist at Miller Tabak.

Also, beware of the bear rally: Crossing Wall Street reminds us that bear markets like this one always include several false starts before a bull comes back:

Since the market broke one year ago, the Dow hasn't been able to sustain one single bear market rally. The largest so far was an 11.2% gain from March 10 to May 2. With yesterday's 10.9% gain, we might able to break that today.

Bear market rallies are very typical in long down markets. The Dow lost 89% from September 1929 to July 1932, however it was anything but a straight line. There were five separate rallies of 23% or more. By "separate rally," I mean that Dow lost everything it gained from the rally and went on to make a new lower. Think about that—each one was a false signal that the bad times were over.

When the Nasdaq dropped 78% in the early part of this decade, there were four separate rallies of 24% or more. Three of the rallies were over 35%.

Just a friendly warning for you.

Lastly, stocks may look cheap, but remember that jumping back in too early can cost you just as much as waiting too long to buy back in. On to the macro factors:

The Economy: Overseas problems remain.
Given all the bad news on the U.S. economic front, it's easy to overlook the rest of the world. Don't.

It's the global slowdown in places like Russia, Korea, and Brazil as well as the United States that we need to keep an eye on, according to Paul Krugman in the NYT earlier this week:

These countries were at the core of the last global financial crisis, in the late 1990s (which seemed like a big deal at the time, but was a day at the beach compared with what we're going through now). They responded to that experience by building up huge war chests of dollars and euros, which were supposed to protect them in the event of any future emergency. And not long ago everyone was talking about "decoupling," the supposed ability of emerging market economies to keep growing even if the United States fell into recession. "Decoupling is no myth," The Economist assured its readers back in March. "Indeed, it may yet save the world economy."

That was then. Now the emerging markets are in big trouble. In fact, says Stephen Jen, the chief currency economist at Morgan Stanley, the "hard landing" in emerging markets may become the "second epicenter" of the global crisis. (U.S. financial markets were the first.)

The severity of declines abroad will matter for global demand as gloomy American consumers continue to downshift. Increasingly bearish Merrill Lynch analysts now see global growth slowing to its lowest levels since 2001 next year. From Merrill:

We now expect the global economy to grow by 2.1% in 2009, the lowest reading since 2001. Driven by the United States, developed markets are now expected to be firmly in recession with growth at -0.4%, the weakest in at least the past three decades. Emerging markets at 5.4% are 2.5 pts lower than two year previously, and the weakest reading since 2002.

Bottom line: The amount of fear in shakier economies than ours sets up the risk of more uncertainty to come, including the stock-specific risk that export growth will slow to a crawl at a time when earnings expectations are already getting some fairly hefty haircuts. At the same time, worries that a slowdown abroad will keep lending tighter for longer than we expect still loom. Until a lot more confidence returns, volatility will be the only sure thing in stocks.