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From the Fed, Mixed Signals for Main Street

Credit...Koren Shadmi

PRICES of stocks, bonds and other investments sank toward the end of the second quarter as the Federal Reserve signaled that it might begin what Wall Street has called “the taper” — the reduction and then the possible reversal of bond purchases that the Fed has used for years to support the economy and markets.

American and foreign stocks, high-grade and high-yield bonds, gold and other commodities and many foreign currencies fell sharply in the quarter’s last weeks, sharply reducing earlier gains. Still, the Standard & Poor’s 500-stock index ended the period at 1,606.28, up 2.4 percent.

The index had been as high as 1,687.18 on May 22, the day when the Fed chairman, Ben S. Bernanke, made a remark to Congress that was thought to herald the taper. The decline in stocks that started that day was accompanied by a drop in bond prices that raised the yield on the 10-year Treasury to 2.5 percent on June 30, from about 1.9 percent when the quarter began.

Mr. Bernanke said the central bank would “take a step down in our pace of purchases” if economic growth continued to pick up, a pledge reiterated a month later in a statement issued by the Fed panel that sets monetary policy. That the markets took his rhetorical clearing of the throat — with no actual change in policy — so badly is especially ominous because the taper wouldn’t signal that something was amiss. Instead, it would mean that precrisis normality had returned, with interest rates set by the markets and not the Fed.

“People are preparing for an eventual cessation to the Fed’s program and an environment where real rates normalize a bit from historically low levels,” said Russ Koesterich, global chief investment strategist at BlackRock. “The reaction was probably more violent than the Fed might have anticipated. No one wants to be the last to leave the party.”

One guest who has grabbed his coat is Daniel O’Keefe, lead manager of the Artisan Global Value fund. He finds fewer prospects in the stock market as something else returns to normal: valuations.

“Over the last four years or so, there has been a steady march up from the bottom, when valuations were extremely attractive,” he said. “That has largely evaporated. I’m not surprised to see the market coming back down.”

Mr. O’Keefe regards American stocks as fairly valued and therefore “just not compelling,” though he still finds opportunities abroad.

James W. Paulsen, chief investment strategist at Wells Capital Management, does feel compelled to buy American stocks. The market has been worried by the run-up in bond yields, but he made a distinction between a “bad yield rise” accompanied by declining confidence in the economy and a “good yield rise” when confidence is rising.

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Ben S. BernankeCredit...Jason Reed/Reuters

Surveying nearly a half-century of market history, he observes that rising yields have been benign when 10-year Treasury rates are below 6 percent and have been harmful when Treasury rates are higher. With the Treasury yield well below that level and various measures of confidence rising, Mr. Paulsen remains bullish on stocks and forecasts a range for the S.& P. 500 of 1,550, near the recent low, to 1,750, which would be a record high. He does not fear the taper.

“Why is the Fed discussing tapering? Why have bond yields been rising since April?” he asked. “Because confidence about the sustainability of this economic recovery is rising.”

Despite a shaky June, United States general stock funds managed a 2.2 percent gain for the quarter, according to Morningstar. Funds that focus on health care, financial services, technology and communication were among the strongest performers, while specialists in commodities and natural resources were conspicuously weak.

Funds that hold foreign stocks fared poorly, too, declining by 2.5 percent, on average. They were pulled lower by emerging markets, especially in Latin America.

The average taxable bond fund fell 2.3 percent, with funds that concentrate on long-term government issues down 6.3 percent.

Daniel Fuss, lead manager of the Loomis Sayles Investment Grade Bond fund, said he expected Treasury bonds to keep falling — or not. It depends on the time frame.

“On a longer-term basis, I think we’re in a secular rise in interest rates,” he said, “but over the last few weeks, the rise in Treasury yields has gotten well ahead of itself.”

Mr. Fuss recommends avoiding Treasury issues and focusing instead on corporate debt, either investment grade or high yield. As for the taper, he contends that it is not a done deal.

“My take is that Bernanke said this whole thing would be data-dependent,” Mr. Fuss said. “The rise in Treasury yields might promote some negative economic numbers, particularly in the residential construction area, so that could be a problem.”

Even before yields rose, some snippets of data were iffy or worse. In late June, the government estimated first-quarter economic growth at a revised 1.8 percent, a sharp reduction from a 2.4 percent estimate in May.

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During the last weeks of the second quarter, Mr. Bernanke’s hint that the Federal Reserve might wind down its longstanding bond-buying program sent stock and bond markets into turmoil.Credit...Justin Lane/European Pressphoto Agency

Komal Sri-Kumar, president of Sri-Kumar Global Strategies, an investment consulting firm, is another who isn’t holding his breath waiting for the taper. He envisions the decline in stocks depressing economic data and sentiment measures, forcing the Fed to reconsider.

“The Fed will say a taper is premature, and the market will be happy because the Fed is not tapering,” Mr. Sri-Kumar said.

He expects a correction in stocks to last well into the summer, then reverse as the Fed signals that the stimulus will continue. But sometime later, perhaps around year-end, investors are likely to sour on the Fed’s perpetual bond-buying, known as quantitative easing, and send stocks into a more meaningful decline, he warned.

“The Fed can’t support the market indefinitely without the fundamentals to support it,” he said. “Eventually the market will realize it.”

Mr. Sri-Kumar considers the 10-year Treasury a buy at its end-of-quarter yield of about 2.5 percent, and he also likes sectors of the stock market that are sensitive to interest rates and have been hit hard lately.

“This is a good time to bottom-fish in utilities,” he said. “They are known as a defensive sector and still offer significant potential.”

But in his view, emerging-market stocks and high-yield bonds, which attract risk-seeking investors, will remain under pressure.

OTHERS have higher hopes for emerging markets. They have been subdued for some time, making them too much of an opportunity to pass up for value investors like Mr. O’Keefe, who is putting money to work there. So is Mr. Koesterich at BlackRock, who also likes economically sensitive domestic stocks in sectors like energy and technology.

“With equity markets, the good news is that they’re reasonably valued in the U.S. and cheap overseas,” he said.

As for Treasury bonds, he expressed the same misgivings as Mr. Fuss and advised steering clear of interest-rate-sensitive assets in general as business as usual returns.

“Over the next couple of years it’s a safe bet that yields are going to go higher,” he cautioned. “A lot of plays that made sense when rates were very low are going to make less sense as the rate environment normalizes.”

A version of this article appears in print on  , Section BU, Page 11 of the New York edition with the headline: Mixed Signals on Main Street. Order Reprints | Today’s Paper | Subscribe

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