Tuesday's fizzled stock market rally shows why there are still plenty of reasons to tread cautiously.
"The market is afraid. Frightened markets don't go up," said John Kosar, chief strategist at Asbury Research.
U.S. stocks rallied along with global equities markets Tuesday but buying faded and what started the day as a strong rally became a rather squishy sell-off. However, the market closed mixed to higher.
"It's really, really early. We did get quite oversold and had a few panic days last week, Friday among them," said Gina Martin Adams, institutional equity strategist at Wells Fargo Securities. "And investors are looking at the broader economic situation and saying maybe the worst is past and we can find some decent values in the equity market now. That said, it's hard to know if oil is finding a bottom, and certainly it helps that China markets had two days of rally. Any stabilization in China is going to be deemed as good news."
China sparked the global risk rally after reporting fourth-quarter growth fell to 6.9 percent, a 25-year low but in line with expectations. The Chinese market rallied, as well as world markets, as investors viewed the data to be better than some of the worst-case expectations and also soft enough to prompt more stimulus from Beijing.
Traders, however, don't trust the Chinese data and a weaker China still tops their lists of worries, along with falling oil, declining U.S. profits and sluggish U.S. economic growth — all while the Fed is preparing further rate hikes.
Tuesday's market action showed how easily spooked investors have become. The Dow had been up more than 180 but turned negative temporarily, and the hit technical resistance at 1,901 and also went negative. The Dow ended the day up 27 points at 16,016, and the S&P 500 rose 1 point to 1881. The Nasdaq remained negative, closing down 11 points to 4476.
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Oil also rose after the Chinese data, but turned lower in Tuesday trading, puncturing the stock market rally and dragging stocks lower as it declined. West Texas Intermediate oil futures closed down 3.3 percent at $28.46 per barrel.
"Our worst-case scenario is that this is another 1998, and we end up trading back down to the long-term trend line, which means we end up bottoming somewhere between 1,790 and 1,800," Adams said. "In the short term, before we extrapolate that, we have to see how the market adjusts to the near-term bottom."
Adams said she is watching the 1,867 level on the S&P 500, the August low. It acted as a support level for the index, which fell below it Friday but did not close below it. The S&P 500 dropped to that level again Tuesday but climbed back above it.
Adams said if it holds the low, the S&P could trade between 1,880 to 2,050 while it works through the issues that are worrying investors.
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Kosar, in a note, says some factors suggest it's still too early to get back into the market on the long side. But he does see some favorable conditions for an intermediate-term bottom over the next several weeks.
One is the historically high put-to-call ratio, a contrarian indicator; the spike in the volatility index, or VIX, and a big flow of investor assets into the money markets. Asbury created a proprietary look at the velocity of money into money markets. The VIX, which had been rising, slipped 3.5 percent to 26 Wednesday.
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But the negatives outweigh right now, including outflows from big ETFs, like the S&P 500 SPDR and the PowerShares QQQ, as well as widening corporate bond spreads suggesting danger still lurks.
"I think there's other significant issues out there other than oil, like break downs in key indexes here," said Kosar.
"When you see trends that originated in '09 which is really when this last move started — '09 after the '08 debacle. When you see those trends being broken and one, two, OK, you're a little bit skeptical, but the power of this and the significance of this is it's happening overseas," Kosar said. The break from an uptrend could be signaling a steeper decline. The Dow transports and the Russell 2000 fell below their March 2009 uptrend lines last week, following the path of the Dow industrials the week before.
He said a similar break in trend lines occurred in international indexes including Japan's Nikkei 225, the Hong Kong Hang Seng and the U.K. FTSE.
"There's indication of weakness that extends beyond oil. Certainly oil is part of that global deflation issue that people are talking about. All of the commodities prices are down. It speaks to global slowdown. Everyone is focusing on oil because it's the shiny object, but there's other things going on out there," he said.
Besides being tugged at by China and oil, the stock market is about to be put to the test by fourth-quarter earnings season. Reports began to roll out last week, and so far three-quarters of about 40 S&P 500 companies have beaten estimates. Earnings are expected to fall 4.4 percent for the S&P 500 companies, and revenues are expected to be down 3.4 percent, according to Thomson Reuters.
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The earnings season could be a catalyst — either way. "The possibility here is that you could have an environment where corporates suggest things aren't getting worse ... the market has traded on this concept that things are getting worse," Adams said. If companies make their numbers and reaffirm guidance that would boost confidence in the market, she said.
But a negative to watch for is companies that are cutting expenses and have no revenue growth. "Ex-energy revenue growth and ex-energy capital spending — I think these are two keys to durability of this expansion in earnings as well as economic growth," said Adams. She said companies outside the energy field did not change their capex plans going into 2016, and it will be important to see if that remains the case.
Richard Bernstein, CEO of Richard Bernstein Advisors, said he has expected the combination of a Fed rate hike and profit "recession" to create volatility, and it has. The central bank raised interest rates last month for the first time in nine years, and the market expects at most just two more rate hikes this year. The Fed however, has forecast four increases.
"Everything else is a sideshow distracting investors. You'd be surprised how much the U.S. market can shrug off, so long as the backdrop within the U.S. is stable," he wrote in an email.
"However, despite what the Fed would like everyone to believe about 'still being accommodative,' stock market movements are based on their incremental moves and not on the absolute level of accommodation. So, their shift toward tightening (admittedly a mild shift) has put the market in a bind because there is negative earnings growth," he added.
Bernstein said the only time the Fed started a tightening cycle during a profits recession was 1981/1982 when the central bank tightened due to double-digit inflation. "China makes for great headlines, but the Fed versus profits is more important if you ask me," he wrote.
But analysts say there are still opportunities. RBC's Jonathan Golub said buying stocks following spikes in the VIX, the CBOE volatility index, has been a positive strategy in the past 25 years, and it worked in October 2014 and in August 2015.
"Our work shows that each 5-10 percent move in the VIX corresponds with a 1 percent move in the S&P 500 in the opposite direction. A move back to more normal levels of volatility represents 7-9 percent upside for stocks," wrote Golub, chief U.S. market strategist at RBC Capital Markets.