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Watch for another selling wave in the stock market as investors are forced out of their low volatility bets

  • Friday's 665 drop in the Dow was a 2.5 percent pullback. There have been 599 one-day drops of that size in the Dow's history.
  • This is how a pullback feels — the sudden urgency of sellers pressuring the indexes through levels that were taken with ease on the way up.
  • Markets rarely bottom on a Friday, so expect at least another selling wave.
  • Watch for mechanical or forced selling by institutions trapped in bets on continued low volatility or assuming negative correlation between stock and bond prices.

This is the market dip you wanted. Or said you wanted, as the market kept levitating without let-up for months. Or thought you wanted, before the reality of a 4 percent one-week tumble reminded us how unnerving a sudden break in stock prices looks and feels in the moment.

But this is how a pullback feels — the sudden urgency of sellers pressuring the indexes through levels that were taken with ease on the way up.

And whenever a market does turn south after months of effortless upside, you can count on there being handy, worrisome headlines and market indicators nearby to get the blame — rising bond yields, wage inflation unleashed, weak Apple iPhone demand, a possible Constitutional crisis.

You thought maybe a dip traveled a gentle slope, stocks trickling lower just a bit each day, all the while whispering, "Don't worry, everything's going to be fine," maybe? Sadly not.

So now what?

Context helps. Sure, the Dow flopped 665 points Friday and nearly 1,100 for the week. But that 665-point drop amounts to 2.5 percent, and there have been 599 one-day declines of that much or more in the Dow in its history — an average of a few per year.

The S&P 500 index fell 3.9 percent last week. It remains up 3.3 percent for 2018. Had someone declared on New Year's Eve that stocks would be up 3 percent by Groundhog's Day atop last year's 20 percent gain, most would have been pleased.

But the path to a 3.3 percent five-week gain matters, in terms of investor emotion and the market's message. We went down 1,000 points in a week the same reason we went up the final 1,000 — not on specific financial calibrations as much as pure psychology and supply-demand.

One week ago, nearly everyone believed the stock market was overbought, over-loved and overheating – and overdue for a dip to refresh the uptrend.

In a column a week ago on the market melt-up and what might come next, I described two simultaneous realities about the market:

"The first idea is that the stock market is comically, almost grotesquely extended to the upside after this near-ceaseless ascent as speculative behavior is heating up and valuation support is waning. The laws of financial physics say this can't persist for much longer. The second idea is that whenever the market has behaved like this in the past, it reflected abiding underlying strength and there was almost always substantial further upside ahead - often with tough downside shakeouts along the way though."

That all pretty much remains the case. Nothing that happened last week suggested the next recession is any nearer, or undid the strength of corporate results this quarter and next.

The tape is now just a bit less extended and seems less invulnerable — that is to say, less abnormally strong and calm. Maybe we're in for a less-generous, more choppy, but still favorable tape from here?

Last week ended the longest-ever streaks without a 0.6 percent daily loss or a 3 percent pullback. So what else are we "overdue" for? Probably a 5 percent retreat. Maybe even a visit to the area of the 200-day moving average, more than 8 percent down from here? Not a prediction, but that's how much more this could drop and still be in a solid uptrend.

Bespoke Investment Group looked at the prior seven times in history a streak of 200-plus days without a 3 percent pullback ended. The market continued to struggle over the next week, but on average did fairly well over the following months and year. Twice these streaks ended near — though not quite at — the final rally of a bull market.

The January upside stampede fed off a rare combination of factors: obvious economic acceleration, enthusiasm over a big corporate tax windfall, a $100 billion rush of new retail investor cash chasing the good news into stock funds and extraordinarily loose financial conditions.

In the short term, the market used up the good news and the new investor cash, while at the margin rising bond yields threaten to make financial conditions less loose.

Just before the worst of last week's drop, Bank of America Merrill Lynch strategists issued a tactical sell signal based on their sentiment and fund-flow gauge, the Bull & Bear Indicator. The firm's downside target on that trade is another 3 percent dip from here.

There is no fixed or reliable relationship between a level of bond yields and equity-market performance or valuation. But clearly the stock market has been trying, fitfully, to come to terms with the steady upward march in the 10-year Treasury, now at 2.85 percent.

Measured various ways, the "equity risk premium" — the added expected return for stocks over risk-free bonds that the market demands - is now at the lowest level in years. That's another way of saying bonds are giving less valuation support to stocks than any time since before the financial crisis.

Still, at many times in prior bull markets, the rate cushion has been slimmer and stocks have handled it. We just haven't stress-tested this economy, this market, and current investor appetites for sustained higher bond yields. This process is underway.

The Bloomberg Barclays Aggregate Bond Index now yields 3 percent. Higher corporate-borrowing rates will work their way through income statements if this continues, and the pain in housing and auto stocks lately suggest yields can crimp consumer activity around the edges.

Then again, the BAML team that saw this coming suggests that the bigger surprise, now that everyone is in an interest-rate panic, "would be a February of weaker macro [data], stronger dollar and lower yields."

For the days to come, the sudden market reversal leaves us in the realm of tactical-trading cues and Wall Street rules of thumb. Among them:

— Markets rarely bottom on a Friday, so expect at least another selling wave.

— Watch for signs that stocks are becoming oversold on a statistical basis. Friday was a pretty good washout day, yielding a few hints that they're getting there: The percentage of S&P 1500 stocks above their own 10-day average is just 12 percent, the lowest since September 2016, says Wayne Kaufman, chief market analyst at Phoenix Financial Services.

— Watch for mechanical or forced selling by institutions trapped in bets on continued low volatility or assuming negative correlation between stock and bond prices.

— The Cboe Volatility Index (VIX) is elevated, above 17, but suggests a more hazardous market and won't hint at a "spike peak" buy signal unless and until it drops hard from there, to about 14.

For investors less concerned with trading the wiggles and waves but trying to stay in tune with the big picture, a few themes I've continued to cite about this bull market remain relevant:

It's not early, but it's not over. This market owes us nothing, but bull markets often give more than is deserved.

And after such a profoundly strong and calm rally such as we saw the past 14 months ends, the first break is usually — usually — not "the big one." Last week, that break arrived.