The violent market sell-off was pretty easy to spot and a long time coming

  • Stocks closed out a tough week with a brutal sell-off Friday that was a long time coming and pretty easy to spot.
  • The market may have grown too comfortable with higher valuations and is now setting itself up for a reset.
  • "The bubble now is in U.S. equities — all the valuation metrics from the 2007 highs have been taken out," said David Rosenberg, chief economist and strategist at Gluskin Sheff.

Vision is always clearer in the rear-view mirror, but this particular sell-off in stocks was pretty easy to spot and shouldn't really be surprising anyone.

A variety of indicators — sentiment surveys, valuation readings, money flows into stock funds — have been screaming sell-off for weeks. That many investors weren't paying attention is pretty normal. When the water looks warm and inviting, everyone wants in the pool.

However, stocks hit a tipping point in recent days when government bond yields started surging, indicating to investors, late though it may have been, that it was time for the market to take a pause.

"We've all talked about how the market does need some sort of capitulation, even it's just 3 percent," said JJ Kinahan, chief market strategist for TD Ameritrade. "Also, people are looking for an excuse to sell. More importantly, people are looking for an excuse to take profits."

They found it once the 30-year bond eclipsed 3 percent and the benchmark 10-year note took out a high that has stood for four years.

But they could have noticed sooner and missed some of the damage caused this week, which featured a sell-off that topped 600 points Friday afternoon on the Dow industrials.

Consider:

  • The Investors Intelligence Survey, albeit a narrow gauge of investment newsletter authors, has been showing its widest spread between market optimists and pessimists since a year before the Black Monday in October 1987.
  • Fund flows, or the amount of cash investors are putting into mutual funds and ETFs, have been exploding in recent weeks, setting record after record in a clear indicator of froth. Bank of America Merrill Lynch's proprietary monitor of flows pointed to a clear "sell" sign earlier this week, but flows had been off the rails for weeks.
  • Valuations have been elevated for a while. Though the price-to-earnings ratio for the S&P for expected profits is at just 18, doesn't look that extreme against the five-year average of 16, pockets of the market were raging. Jim Paulsen, the Leuthold Group chief investment strategist, has been watching the trends and recently concluded that "the U.S. stock market has advanced to a valuation level which is extraordinarily high even relative to the premise of a new permanently elevated valuation range."

In other words, the market may have grown too comfortable with higher valuations and is now setting itself up for a reset.

As much as anything, though, the sell-off over the past couple of days has been about fear that the party is coming to an end.

How does that happen? Economic growth gets too strong, the Fed starts worrying that inflation finally could be setting in and starts feeding rate fears, and suddenly the formula that has driven the bull market for the past eight years starts to not look so strong anymore.

One of the themes that market participants are increasingly talking about, in hushed tones: Comments that new Fed Chair Jerome Powell made back in 2012 at Federal Open Market Committee meetings, expressing doubts over the efficiency of the central bank's market interventions.

"The consensus is that Jerome Powell will not rock any boat and is a [Janet] Yellen clone. I'm not so sure. He doesn't sound that dovish to me," wrote David Rosenberg, chief economist and strategist at Gluskin Sheff. "The bubble now is in U.S. equities — all the valuation metrics from the 2007 highs have been taken out."

Amid this week's sell-off, strategists still expect the market to get back on its feet, and the selling over the past several sessions hardly looks panicky. Still, there are lessons for investors to learn, particularly if the calls for volatility to re-emerge this year are correct.

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