We asserted a few weeks ago that everything was coming up roses for the stock market in January. In February, though, it has been all about the thorns.
To put it bluntly, the stock market has tanked.
The S&P 500 has dropped as much as 11.8% from its record-high close on January 26. It has been a remarkable move for an index that had gone more than 400 trading sessions without a 5% pullback and hadn't seen a 10% correction in nearly two years.
The "correction" that has unfolded, then, has occurred over the course of just ten trading sessions.
A lot happened, but rising interest rates -- or, really, the fear of rising interest rates -- lays at the heart of the matter for a bull market that has been frayed around the psychological edges.
Then and Now
Wait, but weren't interest rates going up in January every step of the way to a 7.5% gain for the S&P 500? Yes. Yes, they were.
The difference then is that the move up in rates in January was rationalized as a sign of confidence in the economic outlook, which in turn was fueling a rotation out of bonds and into stocks.
Now, the perspective regarding the move up in rates has dovetailed into concerns about a rising budget deficit and growing angst that the Federal Reserve isn't going to ride to the stock market's rescue. That perception of matters has been rooted in the following:
- A budget agreement in Congress that will boost spending by approximately $300 billion over two years, provide an additional $90 billion for disaster aid, and extend the debt ceiling until 2019; and
- Several Fed officials downplaying the impact of recent volatility in the stock market while at the same time reiterating the view that a gradual pace of rate increases, most likely three, will be warranted in 2018
We don't want to make it sound as if we are blind to what is taking place in the stock market. A fear of rising interest rates may be at the heart of the matter, but it was some blood clots in the arteries that led to this week's apoplectic shock.
The stock market suffered severely in the past week due to the collapse of short volatility ETFs, which effectively exposed just how ridiculous, levered, and misunderstood some risk parity offerings are.
The collapse of these particular products, as volatility spiked, has forced a re-think of risk exposure across the equity landscape -- from levered ETFs to FAANG stocks to dividend plays.
A collective de-risking, then, has been the spark for the conflagration that has engulfed not just the U.S. stock market but global equity markets.
The dislocation in the stock market on Monday, which produced the largest intraday point swing in the history of the price-weighted Dow Jones Industrial Average and the largest percentage move ever in the CBOE Volatility Index, was jarring in a number of respects.
Most importantly perhaps is the insinuation that there was a mini flash crash driven by algorithmic trading programs. The implication here is that it undercut investors' trust in the stock market once again, which is a key reason why there hasn't been a V-shaped recovery effort.
Instead, there has been an ongoing erosion in pricing and a propensity to sell into strength despite a continuation of impressive earnings news and encouraging economic data.
According to FactSet, the fourth quarter blended earnings growth rate for the S&P 500 increased to 13.9% this week from 13.4% last Friday.
Meanwhile, a somewhat sparse economic calendar this week featured the highest ISM Non-Manufacturing PMI reading since August 2005 and the lowest four-week moving average for initial claims since March 1973. The $53.1 billion trade deficit in December was the largest since October 2008, as imports increased more than exports; however, both imports and exports increased from November in a reflection of the global growth pickup.
The Tale of the Tape
Fundamentals were not the stock market's focal point in this very difficult week. The action of the tape was the focal point.
Market participants were watching the tape for some assurance that this bout of selling has run its course.
Rally efforts fizzled out repeatedly, though, which only exacerbated the selling as weak-handed holders of long positions hoping for a sustained rebound sold out to avoid further losses. In doing so, they only added to the selling pressure.
What was also evident on the tape was a lack of any leadership, meaning there was indiscriminate selling, which is often the case in an expedited effort to de-risk.
When the winners get tossed out just as readily as the losers, it is a symptom of some panicky selling. The ray of hope in that regard is that it can also be interpreted as a sign that a selling climax could be on the horizon.
What It All Means
There is little doubt that the stock market got ahead of itself with its January rally. It was due for a pullback and, well, that pullback has happened -- quickly.
There will be talking heads out there calling this a "healthy correction."
It has been a correction alright, but it hasn't been a healthy one. A "healthy" correction wouldn't entail trap-door action, the implosion of "risk management" products, and a loss of trust in the workings of the stock market.
This "correction" has been nasty like the flu. Fortunately, most people survive the flu, but it takes time to feel completely well again.
That is apt to be the case for the stock market. It has the capacity to fall back on strong earnings growth for some therapeutic support, yet the path of interest rates will be calling the shots in its rehabilitation effort.
We alluded to the importance of that driver in our Market View update in December.
We said then that the stock market might not be overvalued in a relative sense, but that investors needed to bear in mind that the stock market was being propped up in an absolute sense by the persistence of low interest rates. If, and when, those interest rates rise, we added, total return prospects will diminish -- and they could diminish quickly if interest rates move up at a rapid pace and/or the crowd-funded momentum of this bull market gets pulled.
The stock market got pulled apart this week as the crowd disbursed. They may have been driven out more by technical, mechanical, and psychological factors, but the heart of the return matter for the stock market this year will continue to beat to the rhythm of interest rates.