A stun grenade seemingly landed in the stock market last week, with blinding light, noise, and smoke that disoriented equity investors but caused no permanent damage. The broad market indexes managed to set new all-time highs early on, only to suffer a big 1% drop Thursday.

The volatile trading occurred as small-cap stocks flirted with correction territory, continuing a bearish trend that began in March. Meanwhile, the continuing and surprising rally in the bond market is making some investors nervous about the strength of an expected U.S. economic recovery. Such anxiety was confirmed by mixed economic data released last week, with April housing starts and jobs data strong but industrial production and capacity-utilization weak.

Amid these cross currents, the broad indexes finished pretty much unchanged. The Dow Jones Industrial Average ended the week at 16,491.31, down 0.6%, and below an all-time high of 16,715.44 set Tuesday. The Standard & Poor’s 500 ended at 1877.86, flat on the week, but down from an all-time high of 1897.45, also set Tuesday. The Nasdaq Composite bucked the trend and rose 0.5%, or 19, to 4090.59. The Russell 2000 small-cap index fell 0.4% to 1102.91, and briefly dropped 10% from its high on Thursday—technically, a correction.

Despite the index highs, “there’s an incredible amount of pessimism and negativity” in equity markets, says Michael Marrale, head of research, sales, and trading at broker-dealer ITG. He says hedge funds have sharply reduced their equity exposure since March, but he views the selling as a pause, as there is money on the sidelines and people are nervous. “You want to be a contrarian to the pervasive pessimism,” he says.

The mixed data scared stock investors, as “most thought the economy was accelerating,” says Brian Reynolds, chief market strategist at Rosenblatt Securities. He, too, is sanguine, and observes that corporate bond prices are near all-time high.

The bond-market rally was caused by short-covering, the weak industrial-production number, and growing expectations that the European Central Bank will cut rates in June, says Quincy Krosby, market strategist at Prudential Financial. Investors continue to struggle, she says, with how to value stocks in a world where the Federal Reserve is winding down its quantitative stimulus program this year.

(Source: Barrons Online)