This sell-off was long overdue and is likely not the end of the bull market

If the market always speaks a message, then Wednesday’s 800-point tumble in the Dow Industrials and 3.2 percent break in the S&P 500 can be considered the market shouting for attention.

But what is it saying, and how can investors separate the signals from the noise?

Let’s first note that Wednesday’s message, dramatic as it was, was not really a new one, but an accelerated version of market action that’s been evident for weeks. As noted here and everywhere since mid-summer, an unusually large number of stocks have been lagging the rally in the headline indexes. The small-cap Russell 2000 was already down 7 percent from its high even as the S&P 500 held near a record. Housing, auto, airline and semiconductor stocks – to name a few groups – were in steep downturns.

So the big one-day drop was essentially the large-stock benchmarks succumbing to the pressure that had already cheapened the majority of stocks.

This can be viewed as a positive, because by Wednesday’s close the market looks a good deal more “oversold” and washed out than was the case at the start of the January-February correction, which came with most stocks stretched far to the upside.


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So the morning damage assessment shows many of the usual prerequisites for a market bounce in place: Strategist Tony Dwyer of Cannacord Genuity – who has been bullish but expecting volatility and waiting for a better tactical entry point – notes that only one-sixth of S&P 500 stocks finished above their 10-day moving average and just 23 percent of index members are above their 50-day average. That fits with the idea of a comprehensive rout in the majority of stocks, which can present lower-risk rebound opportunities. Note that these readings were much more extreme near the low in February – which makes sense because the total index losses were about twice as large then.

What to watch for

The CBOE Volatility Index surged from below 15 Monday to above 21 – surpassing the 20 level that marks the zone when fear is evident in traders’ demand for downside option protection. Ideally, it’s best to watch for the VIX to spurt to a new high above 20 and then retreat sharply by a few points, closing near lows for the day. That’s a clue that the short-term fever might have broken. The CNN Fear-Greed index of investor sentiment finished Wednesday at 8 on a 0-100 scale – showing extreme anxiety, and near levels often associated with short-term market lows.

Saying the market is “oversold” doesn’t exactly mean it’s an “all-clear” signal that the pain is over. Oversold can also represent urgent sellers swamping demand for stocks – and this can sometimes indicate big investors being trapped and forced to liquidate. In fact, crashes – rare as they are and far from likely right now – tend to occur from oversold conditions.

Wednesday’s air pocket also did not quite represent a reversal of the market’s monger-term uptrend – though that advancing pattern since the spring is now being tested.

Another thing Wednesday’s sell-off was not was a clear expression of alarm over the state of the U.S. economy. Corporate-debt markets, which often grow unsettled at signs of economic weakness before equity markets notice – were a bit softer but remain quite solid, as measured by the yield spreads on riskier bonds. For sure, many cyclical sectors such as housing, transportation and even retailers have been in a tailspin. This mostly reflects worry over the duration of this cycle, potential for profit deceleration and long-term disruption by tech innovators than real weakness in employment, consumer spending or business investment.

For sure, the backdrop includes the quick jump in Treasury yields, which raises questions about how well the economy can handle higher debt costs as the stimulating effects of the tax cuts abate into 2019 and cost pressures pinch corporate profit margins. But this is not the same as the market sounding a loud warning on an oncoming recession.



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So what is the market saying?

For one thing, that we had been living with a market that had grown unbalanced and unwieldy in a couple of ways: The spread between the U.S. market performance and struggling global markets had become very stretched. And the dominance of Big Tech and other mega-cap glamour growth stocks had become extreme, with too many big investors betting blindly on their continued leadership.

So Wednesday’s shakeout – which included the popular iShares Edge Momentum Factor ETF (MTUM) dropping a nasty 5.2 percent – can be viewed as a violent “positioning shock,” when crowded trades were upended in a hurry as the market in general struggles to revalue strong but decelerating earnings at a higher bond-yield level. The bull case for many of these stocks simply came to seem too obvious to too many and the market doesn’t reward the obvious trade indefinitely.

Consider the remarkable example of Amazon. The stock is down more than 16 percent – from $2,050 a share and a $1 trillion market capitalization midday on Sept. 4 to $1,703 and an $830 billion market value now. Nothing much has changed fundamentally. Sure, the company raised its minimum wage for workers to $15 an hour, but that’s not the story here. The Street just fell too hard in love with the supposed eternal dominance of the company – and that kind of blind, unconditional love makes the smitten admirer quite vulnerable.

It’s a noisy environment and will probably remain a nervous, irresolute and mercurial tape for a while. I noted on Monday morning that the bears had an opening to get the upper hand this month. But right now the market has not delivered a clear signal that the broader bull market is ending. For once, stocks have become much cheaper and less loved heading into earnings season, perhaps a better setup than rising into reporting season on a high.

It’s become a less-generous market, one in which every driver of positive feeling (strong economy, surge in earnings, U.S. growth outperformance) kicks up offsetting forces (rising bond yields, Fed tightening, global imbalances). It is certainly a late-cycle environment, with all the jitters that brings. A bear market of some description will come at some point, and if it’s close that would represent no great injustice or anomaly; this bull market doesn’t necessarily owe investors any more than it’s given.

But knowing what we know now, it’s likely that the latest skid is another gut check for investors – one that may not be over yet – rather than an existential threat to the bull market.


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