Gloomy Economic Reports Trigger Alarm Bells on Wall Street

On top of emerging market chaos and Fed uncertainty, investors are now grappling with fresh signs the     U.S. economy is reverting back to its sluggish growth trajectory.

Recent economic indicators have revealed that U.S. manufacturing activity fell to eight-month lows, durable goods orders unexpectedly tumbled and pending home sales slumped to the slowest pace since September 2011.

With the Dow Industrials flirting with a 300-point plunge on Monday, this string of ugly economic indicators raises the pressure on upcoming economic reports to deliver, especially Friday’s crucial monthly jobs report.

“It’s just not a strong or vibrant recovery. It tends to go in fits and starts. We’re starting to see that in the statistics again,” said Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at KeyCorp’s (NYSE:KEY) Key Private Bank.

While U.S. markets have been hit by a wave of selling, some market strategists are urging their clients not to panic -- yet.

Investors “need to resist the urge to retreat from short-term volatility. Rather, they should embrace the opportunities it creates," Kristina Hooper, U.S. investment strategist at Allianz Global Investors, wrote in a note on Monday.

The latest blow was delivered on Monday by the Institute for Supply Management, whose closely-watched gauge of U.S. manufacturing activity slumped to 51.3 in January from 56.5 in December. That wasn’t even close to consensus calls for a slight dip to 56.0 and represented the weakest level since May.

The internals weren’t much better as new orders plunged to 51.2 from 64.4 and employment slid to a nine-month low of 52.3.

Economic Slowdown

It’s worth pointing out that the ISM cited weather as a factor behind the weak report, suggesting extremely cold temperatures throughout much of the country derailed manufacturing activity.

“Weather is always a convenient excuse, even though it is usually cold in January, but the extent of the disruptions we’ll give the benefit of the doubt to for now,” Peter Boockvar, chief market analyst at The Lindsey Group, wrote in a note to clients.

“Should we take the money and run? I don’t think so."

- Ed Yardeni of Yardeni Research

By itself, the ISM report wouldn’t trigger all that much concern amongst investors. But this important indicator comes just days after the government said durable goods orders slid 4.3% in December, the largest decline since July. Economists had been banking on a 1.8% gain.

Other reports released last week revealed new home sales dropped 10% in December and pending home sales decreased 8.7%, widely missing estimates for a dip of 0.3%.

Volatility Grips Stock Markets

Plus, emerging market currencies of economically and politically-challenged countries have been in free fall in recent weeks. The emerging market turmoil in Argentina and elsewhere has sparked concerns about contagion or even another banking crisis.

That backdrop helps explain why investors yanked $6.4 billion from emerging market stock funds in the week ended January 29, according to a Bank of America Merrill Lynch (NYSE:BAC) report entitled “First Signs of Panic.” That marked the largest amount of outflows since August 2011.

Monday’s gloomy ISM report helped spark another steep pullback on Wall Street as the Dow Industrials lost almost 300 points. The selling left the S&P 500 in “pullback” territory, which is a technical term for when an index trades more than 5% below a previous high. If the broad index closes below 1755.96, it would represent its first pullback since June 24.

The Dow Industrials tumbled 878 points, or 5.30%, in January, their worst monthly percentage decline since May 2012 and coldest January since the Great Recession in 2009.

To put the recent market volatility into perspective, the Dow has already experienced two intraday drops of 200 points in just 22 trading days this year, compared with seven such days in all of 2013.

Will the Fed Blink?

“There is now a fair bit of pressure on Friday’s employment report to deliver a strong reading. With the FOMC pulling back, investors most certainly want to be reassured that the economy is not pulling back in tandem,” Dan Greenhaus, chief global strategist at BTIG, wrote in a note to clients.

Now speculation is mounting over whether the Fed will abandon its plan to dial back QE. However, the central bank, which is now being led by Janet Yellen, did not even mention the market volatility when it announced plans to cut QE by an additional $10 billion a month last week.

“I think it would be unwise for them to be totally oblivious. At some point, they’re going to have to be concerned the turmoil in the markets disrupts consumer and business confidence,” said McCain.

The string of ugly economic reports raises the stakes for Friday’s jobs report, which economists believe will show the U.S. added about 190,000 jobs in January after gaining a paltry 74,000 in December.

If the jobs report is very weak, “I think you could see a pretty severe reaction” in the stock market, said McCain. “When the entire herd gets nervous any disruption takes on magnified effects.”

Time to Retreat?

While many investors are panicking, some market veterans see opportunity amidst the chaos.

“Should we take the money and run? I don’t think so,” Ed Yardeni, president of investment advisory Yardeni Research, wrote in a note to clients on Monday.

Yardeni, who has been bullish on the market since the March 2009 bear market lows, notes that market bears incorrectly forecasted doom many times over the past four years.

“The bears were very helpful in setting up the stock market for powerful relief rallies. They might be doing it again. If their latest bearish assessments also don’t pan out, then we can expect yet another relief rally to record highs,” said Yardeni, who reaffirmed his year-end S&P 500 price target of 2014.

Michael Block, chief strategist at Rhino Trading Partners, said his clients remain torn.

“For every contact I have saying ‘enough’ and planting his/her feet in the clay, I have yet another rubbing their bearish paws with glee and saying that now that month end support is gone, we are going to melt down,” Block wrote in a note.