Why the Dow Went Haywire This Week

For those of you who follow the day-to-day movements of the Dow Jones Industrial Average , here's the big news this afternoon: The Dow is doing a whole lot of nothing this afternoon, up a modest 30 points following a massive drop yesterday and a dearth of economic news today.

In light of the relative inactivity today, I wanted to offer a more global view of what's been roiling the markets of late and why it matters.

The natural starting point is the Federal Reserve. Since last September, the central bank has purchased $85 billion every month in Treasuries and agency mortgage-backed securities. The underlying policy has been termed "QE3," because it's the third round of so-called quantitative easing. The purpose of quantitative easing is to drive down long-term interest rates -- and in this aim it has succeeded.

Between 2008 and the middle of last year, the yield on the 10-year Treasury bond -- one of the most frequently cited interest rates in the world -- was more than sliced in half, falling from more than 4% to less than 1.5%. And when you back up and look at the longer-term trend, you see what probably amounts to the culmination of an unprecedented 30-year rally in bond prices. To be clear, bond prices and yields move inversely, so the lower the yield, the higher the bond price.

10 Year Treasury Rate Chart
10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts.

But now it's time to forget all of this. Given the Fed's recent intimation that it may start to reduce its monthly purchases, the bond market has turned violently. Over the past year, the yield on the 10-year has increased by a staggering 63%. And it's for this reason that speculators are piling into exchange-traded funds that short Treasury bonds (bets that bond prices will go down), as opposed to long funds (bets that bond prices will go up). Since the beginning of May, for instance, the Proshares UltraShort 20-Year Treasury is up by 24%.

And it's also for this reason that shares of the nation's largest homebuilders took an absolute beating yesterday. To provide just one example, PulteGroup was off by more than 10% at one point. As mortgage rates, which are lashed to long-term interest rates, have shot up over the past couple months, the fear is that home buyers will respond in kind -- that is, by not buying new homes. I tend to think that yesterday's moves amounted to an over-reaction, but many people clearly seem to disagree.

In terms of stocks more broadly, they too are feeling the effects of a presumed retreat by the Fed -- I emphasize the word "presumed" because it's far from certain what the central bank will actually do. As I discussed earlier, when bond yields started to plummet, investors began trading out of bonds and into stocks in a frantic hunt for yield. That sent the major indexes to all-time highs. But as those bond yields go back up, the flow of liquidity will reverse. This is why my colleague Alex Dumortier wrote an article yesterday entitled "Stocks: The Liquidity Rally Just Died."

The net effect is that the market is being driven almost exclusively by speculation about what the Fed will or won't do over the next few quarters. This, mind you, is a speculative exercise at best, and a foolish one (with a small "F") at worst. As a result, true investors would do themselves a favor by ignoring this short-term volatility and keeping their focus on the fundamentals.

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