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Volatile market crosses into a 'different world'

A market priced for perfection will start to wilt when investors realize things aren't particularly perfect.

Such is the lesson on Wall Street, which saw another huge selloff Tuesday that seemed to lack a significant catalyst.

Sure, there was the overnight economic news out of China, where a key manufacturing index fell to a three-year low. But everyone knew and expected that the reading wasn't going to be particularly inspiring.

A market looking to sell, however, is going to sell, and that's particularly true when stocks are at least fairly valued and in many cases overvalued. Prior to the August selloff, which saw major averages dip 6 percent and fall into correction territory, the equity indexes had been priced to reflect a belief that the U.S. economy would grow around 3 percent, the global economy also was fine and the Federal Reserve would find a way to remain accommodative.

With those and other assumptions challenged, the market finds itself teetering precariously between a fairly routine selloff in the context of a broader bull, and one looking to price in the vacillating probabilities of a global recession.

Traders work on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Traders work on the floor of the New York Stock Exchange.

"If you've got a vulnerable market like that, then anything can be the straw that breaks the camel's back. I think we overplay China and commodities prices. It's certainly the thing that broke it, but it's not the thing that caused it," said Jim Paulsen, chief investment strategist at Wells Capital Management. "The real cause was growing vulnerabilities of the market. Until we purge some of those, it's hard to get back on the launchpad."

Those vulnerabilities include the usual suspects named above as well as a stronger dollar, weakening earnings picture and soft spots around the world beyond China, such as Brazil.

Trillions of Fed liquidity—$3.7 trillion in all, bringing the central bank's balance sheet to $4.5 trillion—did an exemplary job of masking those weaknesses since the financial crisis. No more: The Fed cut off its quantitative easing lifeline to markets in October 2014, with a long-anticipated hike in interest rates on its way, perhaps as soon as September.

Read MoreSeptember shaping up as Fed's worst nightmare

"We're no longer going to have the liquidity friend we used to have. That's a very different world," Paulsen said. "In the previous world, you could do fine with 18, 19 times earnings with slower earnings growth. In the forward world, we can't. You're going to have to grow with 15 or 16 times, and you're going to have a more cautious investor, one that's not overpaying for story stocks."

What characterizes the market most now is not movements among various sectors or asset classes, but rather sheer volatility. The word is most often synonymous with downward movements in the market, but that, too, has changed.

This market has been prone to wicked shifts higher and lower, with the Dow Jones industrial average in some sessions traveling thousands of points in either direction.

Indeed, the top seven best-performing exchange-traded products in August all involved volatility plays, with leveraged funds scoring particularly huge gains:

The volatility play

Fund name
Ticker
August gains (%)
Pro Shares Ultra VIX Short-Term Futures UVXY 159.41
VelocityShares Daily 2X VIX Short Term ETN TVIX 159.3
C-Tracks Citi Volatility ETN CVOL 89.34
ProShares VIX Short-Term VIXY 67.67
iPath S&P 500 VIX Short-Term Futures ETN VXX 67.6
VelocityShares VIX Short Term ETN VIIX 67.5
Velocity Shares Daily 2X VIX Mid Term ETN TVIZ 54.04
Source: ETF.com

"We've had these wild swings not just for the day compared to yesterday, but these big intraday moves. That's really changing the market," said Uri Landesman, head of hedge fund Platinum Partners. "It's going to be that way at least for the rest of the calendar year."

Landesman, who has a generally bearish tilt on the market, said he believes the S&P 500 can continue to fall but likely will find firm support around the 1,800 level, or about 6.5 percent from Tuesday's trading level.

All the turbulence has created a fertile playing field for those who trade the market on a short-term basis, but otherwise has sent many to the sidelines.

Read MoreInvestors have been making a mad dash to cash

Even the $2 trillion ETF world, which is heavily populated with traders, saw U.S. stock funds lose $2.5 billion in assets for August while international funds saw $3.8 billion in outflows, according to ETF.com.

"When you look at the month of August, you will see the S&P, the Nasdaq and the Dow down almost identical percentages, and that rarely happens," said Art Hogan, chief market strategist at Wunderlich Securities. "What that tells you is this is risk-off selling of index ETFs."

Still, no one seems to be ready to say goodbye to the bull market.

The most recent American Association of Individual Investors sentiment survey recorded bullishness, or the expectation that the market will be higher in six months, at 32.5 percent, which, though well below the historical norm, was the highest in a month. At the same time, bearishness, also rose, to 38.3 percent and above its historical trend of 30 percent.

Read MoreHere's why it can get much worse: Technician

Mark Zandi, chief economist of Moody's Analytics, said he continues to believe the U.S. economy is on a steady growth trajectory but sees the market struggling.

The market is "highly valued and remains vulnerable," Zandi said Monday during a conference call with reporters. "I wouldn't be surprised if the current volatility ... isn't over, if there isn't some more wringing out here given valuations."

Correction: Stocks sold off sharply Tuesday. An earlier version misstated the day.