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This sell-off will only turn into a correction if Trump's scandals put tax reform at risk

  • Stocks in one of worst sell-offs since election on concerns Trump agenda will be impacted by latest controversy.
  • Strategists don't expect a major correction unless tax reform is no longer expected.
  • 'Buy the dip' strategy expected to keep the pullback from escalating.

Stocks sold off in the strongest reaction yet to political controversy surrounding the Trump White House, but the market is not likely to head into a serious correction unless it appears the chaos disrupts any chance for tax reform.

Both the S&P 500 and Nasdaq were at record highs this week, but then Washington became the epicenter of a new series of political shockwaves that threaten to distract the White House and Congress from President Donald Trump's economic agenda. On Wednesday, the S&P fell more than 1.2 percent to 2,370 in one of its strongest sell-offs since the November election. The Dow was down more than 250 points, and the Nasdaq dropped 1.8 percent.

"If the market wasn't overvalued, I wouldn't worry so much. An overvalued market is looking for a catalyst for a correction. This could be it," said Jack Ablin, CIO of BMO Capital Markets. "I wouldn't run away from the market for fear of some sort of collapse. ... The U.S. market is somewhat over its skis."

The odds for tax reform have been waning as more and more controversy swirls around the Trump White House. Initially expected this year, analysts say many investors now expect it next year. But the idea that it would not be possible at all, would be a blow for a market building in expectation of tax cuts that could boost the economy and corporate bottom lines.

Treasury yields, which move opposite prices, went lower as investors sought safety, and the dollar continued a multiday decline. Gold futures were higher, and investors piled into the SPDR Gold Trust, driving it 1.6 percent higher in a flight-to-safety trade.

Stocks had largely been complacent about a series of recent events that raised the potential for political risk from Washington, starting last week with Trump's firing of FBI chief James Comey, who was investigating the ties between Trump's campaign and Russia. It was also revealed earlier this week that Trump allegedly told classified information to key Russian officials, who visited the White House last week.

But the stock market did react when it was revealed in news reports that Comey left behind a memo saying that the president asked him to drop his investigation into former national security advisor Michael Flynn, who was at the heart of the Russia investigation. That brought calls for impeachment from some Democrats and also raised questions of whether Trump overstepped any legal bounds.

"The worst-case outcome is if something happens with the presidency. The bigger thing is we're back to the question of is this bad enough to put the agenda on the back burner because they have to spend all their time defending. To me, that's really what's showing up here," said Bill Stone, chief investment strategist at PNC Wealth Management. "Impeachment when you've got your party controlling Congress is not going to happen. ... The markets are barely off their highs. It's not the end of the world."

Analysts say they still expect "dip" buying, or investors with lots of cash to jump in as the market declines. That trade has also been a hallmark of the bull market.

"My sense is we go down a couple of percent, and then investors come out of the woodwork and buy. They're going to buy the 'impeachment' dip," said Ablin.

Daniel Suzuki, equity strategist at Bank of America Merrill Lynch, does not expect a major correction from the latest events. "Even if we were to get a correction, we'd be buyers of that dip or correction. As far as the market is concerned, it should have long-lasting impact on the environment for the market and corporate profits overall," said Suzuki.

Stone said the market will be looking for reassurance from Congress and other officials that the tax plan is still a top priority. Traders say they are watching to see if there are any other defections

"Watch the tape today, if special prosecutors are hired or there is more talk about obstruction of justice being an impeachable offense, one can kiss the tax plan, health-care plan, and fiscal stimulus plan goodbye for 2017 ... today is one of those days where we have to watch the politicians ... for a conservative strategy, we still like the credit space ... safest for now," National Alliance's Andrew Brenner said in a note.

Julian Emanuel, equity and derivatives strategist at UBS, saw Wednesday's sell-off as an extension of the sideways correction underway for weeks, as the S&P 500 slowly climbed to new highs and volatility hit new lows. The VIX on Wednesday surged, jumping more than 22 percent to about 13, after falling below 10 a week ago. The VIX is the CBOE's Volatility Index, based on puts and calls in the S&P 500.

"To us, a correction in time morphing into a 7 to 10 percent pullback, like we've seen every seven or eight months over the course of this bull market since 2009, is definitely something we think could be in the offing," Emanuel said. The strategist said he recommended over the weekend that investors move into June puts, or options that make a negative bet, on the S&P 500.

"There is no question that politics has raised the level of uncertainty in the market, which tends over time to be something that depresses valuations. What we've had is this divergence between the economy and confidence, based on the expectations that there would be stimulative policy coming out of Washington," he said. "We haven't seen the economy picking up consistent with these elevated confidence readings. It's going to be important to watch whether the economy begins to accelerate."

While stocks edged to highs, the Treasury market had moved to price out an economic bump from the Trump policies. In fact, fed funds futures are no longer forecasting two Fed rate hikes this year, based on weaker-than-expected data, particularly inflation. The Fed is still expected to raise interest rates in June, and it forecasts two rate hikes by year-end.