Stocks in sharp correction but no bear market—yet

A trader on the floor of the New York Stock Exchange, January 7, 2016
Brendan McDermid | Reuters
A trader on the floor of the New York Stock Exchange, January 7, 2016

While U.S. stocks are facing a fast and sharp correction, they are still not expected to fall the 20 percent that would signal a bear market, analysts say.

The Dow and Nasdaq both dropped into correction territory Thursday, trading 10 percent below their 2015 highs, as a global equities sell-off gained momentum.

Stocks tumbled after China's Shanghai market again plunged 7 percent before being halted for a second time this week. China responded by removing circuit breakers that halted the trading, temporarily sending some relief into markets.

The S&P lost 2.4 percent Thursday and is down nearly 9 percent from its all-time high in May. But the index has lost nearly 6 percent since Dec. 30.

For Friday, traders are bracing for the December employment report, expected to show 200,000 nonfarm payrolls and an unchanged unemployment rate of 5 percent, according to Reuters. But the market focus is much more on China and how its markets trade overnight.

"China seems to be the lead story and everything seems to be following," said Art Hogan, market strategist at Wunderlich Securities. "The moves we've seen this year are just so neck breaking,"

"A 10 percent correction doesn't matter. It's a question of how much damage it's done in a very short amount of time," said Hogan.

Markets have been spooked by China's stock market declines, but more so the drop in its currency. The yuan has been losing ground against the dollar since the International Monetary Fund granted it reserve currency status in late November.

The fear is that China will export deflation with the devalued yuan.

"If a bear market means the market is going down 20 percent, I don't think we're going to be down 20 percent this year. Could we be down? Yes. But I think it's more likely we will be down modestly," said Bob Doll, senior portfolio manager and chief equity strategist at Nuveen.

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Doll said the current sell-off is very similar to the China-fed market correction in August, that took the S&P 500 down 11 percent.

The sentiment on China then was "It doesn't know what it's doing. They're having technical issues around the markets. Their currency is falling. There's the unanticipated devaluation. Commodity prices were going down, and people were concerned they weren't able to control it, and the world would be in a deflationary spiral," said Doll.

The China fears have crept back into world markets, as concerns about U.S. economic weakness have increased. Fourth-quarter growth is pegged at just 1 percent by many economists, and the weakness comes at the same time the Fed has started raising rates.

The outlook for U.S. corporate earnings remains weak and deteriorating manufacturing data have raised concerns that there's even more weakness ahead.

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Oil prices have been another nagging worry for stocks, and this week U.S. crude futures plunged 10 percent, touching 2003 lows briefly Thursday.

"I do think this sell-off (in stocks) is warranted. Every risk we worried about is materializing, particularly when it comes to currencies and commodities," said David Bianco, chief U.S. equity strategist at Deutsche Bank.

While he said his earnings forecast is at risk due to collapsing energy prices, he still expects the S&P to reach 2,250 by year-end. "I don't think we go to the August lows." The S&P 500 fell to a low of 1,867 in August.

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"I think there's plenty of earnings risk, but the earnings risk is still concentrated at those same commodity and emerging market-exposed sectors," said Bianco.

Doll expects China to succeed in stabilizing its markets. But the concern is that it's not managing its message well.

"I think China is managing their economy fairly well given the challenges. I think they run into a lot more challenges trying to manage the markets, and they're learning quickly that trying to manage a market is harder than managing an economy," said Bianco.

The decline in China's currency has raised fears of further devaluation and markets shuddered Thursday after a news report suggested a 10 percent or more decline.

Peter Donisanu, global research analyst at Wells Fargo, said it could be meaningful that the currency moved lower after the IMF ruling in late November.

"To me that says the [People's Bank of China] has reduced its role of supporting the yuan versus the dollar," said Donisanu. He added that China has said its currency should be pegged to a basket of currencies but the markets watch the yuan versus the dollar.

"I think it's more of an adjustment period. it's something new. It's a new policy perspective," said Donisanu.

The weakening currency has been blamed on perceptions that the economy is slowing further, as well as capital flight from China.

Donisanu said the December data from China and fourth-quarter GDP will be especially important. GDP is expected Jan. 18.

"The thing that right now feels different than August of last year is the data flow has been improving a little bit," said Bruce Kasman, chief global economist at JPMorgan. He too is looking forward to the Jan. 18 data.

"The question is how much of this is equity market volatility, which isn't really telling you about the macro economy, and how much of it really is that there's a change in the macro economy," he said.

Kasman said a problem has been that China has not communicated its currency strategy well, and the markets have been confused by it.