What's next for stocks?

After a gut-wrenching week that included a 1,000 point plunge in the Dow, investors may want to strap in for another bumpy ride. The volatility looks set to continue this week as the stage is set for a showdown between bulls and bears betting on the direction of the U.S. economy.

The outcome will determine, in large part, whether the Federal Reserve raises interest rates in its September 17 policy announcement for the first time since 2006. That's a big deal. Fear of policy tightening was a major factor behind the sharp swings that rattled investors, driving many to seek refuge in cash and other safe-haven investments.

After plunging earlier in the week amid mounting concerns about China's economy, U.S. stocks started their climb higher on August 26 after New York Federal Reserve President William Dudley said the case for a September rate hike was "less compelling" in light of recent market volatility. The message for investors? The Fed is very sensitive to financial market conditions and is willing to step in and conduct "verbal easing" as necessary to stem stock routs.

On Friday, the start of the Jackson Hole, Wyo. Symposium provided plenty of Fed-related headlines. Vice Chairman Stanley Fischer said it was "too early to tell" if the central bank should pull the trigger on a rate hike in September. Atlanta Fed President Dennis Lockhart said market turbulence makes him less resolute about a hike. Cleveland Fed President Loretta Mester reiterated her feeling that the U.S. economy is ready for a hike.

St. Louis Fed chief James Bullard noted the last 10 days shouldn't change the Fed's outlook "very much" given the strength of the economy. And Minneapolis Fed President Narayana Kocherlakota, a noted policy "dove," said he doesn't believe the time is right to start pushing up rates.

With the decision apparently on a knife's edge, all eyes will be on the flow of economic data. On Friday, the July personal income and spending data came in largely as expected, with income up 0.4 percent, matching the rate of the last three months. Durable goods spending also rose.

The spotlight this week will be on the U.S. Labor Department's latest readout on the job market on Friday. Deutsche Bank expects a payroll gain of 170,000, below the year-to-date average of 211,000, as seasonal factors have resulted in soft August job reports in each of the last four years. Looking back since 1988, the month has disappointed forecasters in 21 of the last 27 years.

Two caveats. Deutsche Bank analysts still expect the unemployment rate to fall to 5.2 percent, and they think the underlying health of the job market is good. But the atmospherics of the payroll miss would probably put the September rate hike on ice, clearing the way for stocks to continue their rebound.

If so, gold, oil and other commodities should continue their recent rise on a bounce-back in inflation expectations.

deadth-cross.png

The case isn't so clear cut for stocks, however, given the S&P 500 suffered its first "Death Cross" since 2011 on Friday as the 50-day moving average moved below the 200-day average, a sign of failing medium-term momentum.

The poor technical outlook is offset somewhat by the fundamentals, with Credit Suisse noting that "too much of a slowdown in growth is being priced in" relative to where the global economy is. The ratio of stocks to bonds is essentially saying the U.S. economy is about to stall out. Should crude oil keep rising, some of the pressure on corporate earnings will be lifted as well.

outflows.png

For their part, retail investors are bracing for further declines, with bond and stock mutual funds suffering their first back-to-back monthly outflows since the financial crisis, according to data from the Investment Company Institute. A

Notes Credit Suisse analyst Dana Saporta, "It may be that the intensity of the recent equity market declines have tested the risk tolerance of retail investors who have shown no desire in recent years to take another wild market ride."

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.