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Wednesday could be important turning point for stocks after Congress chills rally

The stock market will get its swagger back, but there could be more selling this week as Congress wrestles with the fate of Obamacare.

Stocks were trounced Tuesday on concerns the House will not have enough votes to repeal and replace the Affordable Care Act, triggering worry that more of President Donald Trump's pro-growth policies could be delayed or derailed in Congress. It was the worst sell-off since just before the election, and the first time the market reacted negatively, amid doubts about Trump's policies becoming law.

While that was the catalyst, strategists see the potential for a continued pullback, though not necessarily a deep one. UBS equity and derivatives strategist Julian Emanuel said he has been expecting a pause and sees a 5 to 10 percent correction before stocks move higher again.

Traders work on the floor of the New York Stock Exchange.
Brendan McDermott | Getty Images
Traders work on the floor of the New York Stock Exchange.

It will be important to watch how stocks trade Wednesday after Tuesday's market sold off on heavy volume. The real tell for the market will be after the House votes on health care on Thursday.

"When Washington controls who's driving the bus, it's impossible to say" what the market will do, said Peter Boockvar, market strategist at The Lindsey Group. "But if they pass it, the market could rally."

The Dow fell 238 points Tuesday, or 1.14 percent to 20,668, in its worst decline since Sept. 13. The S&P 500 lost 29 points, or 1.2 percent, its worst day since Oct. 11. The Russell 2000 small-cap index was the worst performer, losing 2.7 percent, and Nasdaq declined 1.8 percent to 5,793. Financials were the worst sector, down 2.9 percent.

"It's pretty easy to see this as almost a risk re-set. That's what we've been looking for and we think you are in the midst of it," Emanuel said. The strategist said the things he's most watching to gauge market performance are whether consumer confidence stays high, and also whether the retail buyers continue to step in to support the market. "Can confidence figures be maintained where they are now? And will the public continue to be the incremental buyer? If either one of those degrades at all, that opens up the case for more downside."

So far, the analysts are not that concerned about the ultimate prospects for tax reform, and they expect Congress to pass tax breaks for corporations and individuals at some point. However, if that looks to be at risk, they say all bets are off since it has been the policy with some of the most promise for future stock market gains.

There are a number of signals that strategists have been watching, some of which have foreshadowed a pullback. Emanuel said he's been watching the VIX, the CBOE's volatility index, which has been trading at very low levels, indicating investors haven't hedged for market volatility. A low VIX is a sign of complacency, and the VIX jumped 10 percent to a still low 12.46 Tuesday as the stock market sold off.

Emanuel said he is also concerned that investors expect too much from earnings this year, based on the promise of tax reform, and the market needs to adjust that expectation. He said the difficulties with health-care legislation are affirming his view that much anticipated tax reform will not be approved until very late in the year or in 2018.

Strategists say with the sluggish growth expected in the first quarter, there could be some investors concerned about the Fed's hiking cycle. Yields were lower in the Treasury market Tuesday, with the 10-year at 2.41 percent late in the day. While the Fed's forecast for rate hikes this year was not as aggressive as some expected after its meeting last week, the market reaction has been the opposite of what one might expect.

This decline in yields, which move opposite to prices, is a bit of a concern to Ari Wald, technical strategist at Oppenheimer. While Wald said he is not worried yet, he was surprised the 10-year Treasury yield could not break through the upper end of the range and test 2.65 percent, after the Fed raised rates and said it would hike two more times in 2017. He is now watching to see if it goes to the low end of the range — at about 2.3 percent.

"If you were to break below 2.3 percent, I would worry. I generally view that the direction is equally important as the level," he said. Wald said falling interest rates signal a deflationary global growth scare, though that is not currently the case. He also does not expect the market sell-off to persist due to strong seasonality in March and April. However by summer, it would not be surprising for the S&P to give back as much as 8 percent, he said.

Ryan Detrick, LPL Financial senior market strategist, said he expects some more selling. "We're still modestly off the all-time highs, and our general opinion is this could come in a couple more percent or so, but when you look at the economic backdrop, which is positive, it doesn't signal a major correction and it could signal a buying opportunity," he said.

But there are some warning signs he's watching. "Small caps continue to break down. That's obviously a warning sign. Crude and small caps are the two big ones. Both of these were cracking before today. Those are the harbingers we're watching. If those continue to weaken that could be a sign that more weakness could be coming into equity markets," Detrick said.

Oil could be an important mover Wednesday, with government inventory data due at 10:30 a.m. ET. West Texas Intermediate futures fell to $47.34, a four month low in the risk-off environment Tuesday. WTI was down 1.8 percent, and could dip further if inventories show a larger-than-expected increase.

Detrick said the pullback was not a surprise, especially after the stock market went for so many sessions without a 1 percent or more drop in the S&P 500.

"We went 109 days without a 1 percent close lower on the S&P, which was the longest since 1995," he said. "When you have these long stretches without a 1 percent drop, the returns going out six to 12 months are actually very strong. It's kind of opposite of what you might think."

He noted there were 12 previous times since 1950 when there was a stretch of 100 days or more without a 1 percent decline. He said six months later, the median return was 6.7 percent and a year later it was 14.4 percent.