The bull market looks safe for now

  • The weight of the evidence now suggests we're in a nasty, anxious correction rather than the kind of prolonged downturn of 20 percent or more.
  • Before this month, a drop of 10 percent from an all-time high in less than two weeks hadn't happened since 1928.
  • Bear markets outside of recessions aren't common but have happened.
  • This is a valuation, sentiment and investor-positioning reset, with an exacerbating "X-factor" of a crowded volatility-trade unwind.
People with umbrellas pass by bull and bear outside Frankfurt's stock exchange during heavy rain in Frankfurt, Germany, November 20, 2017.
Kai Pfaffenbach | Reuters
People with umbrellas pass by bull and bear outside Frankfurt's stock exchange during heavy rain in Frankfurt, Germany, November 20, 2017.

Every bear market starts as a correction, but fewer than half of all corrections deepen into bear markets.

Now that the U.S. stock market has shed one-tenth of its value in two weeks in a sharp correction, the fate of this downward break in prices has investors in suspense.

The answer is unknowable, But the weight of the evidence right now suggests we're in a nasty, anxious correction, rather than the kind of prolonged downturn of 20 percent or more that would place the bears in control.

That doesn't mean we've surely seen the low for this decline, even though Friday's upside reversal had some features of a good short-term bottom. It also might not mean a quick return to the record index highs of Jan. 26 or to the kind of effortless upward climb that preceded it. We've probably seen the best this market has to offer in terms of the gain-versus-pain ratio reflected in the low-volatility levitation of last year and January.

Yet stocks can likely work their way higher on sturdy corporate profitability and steady global expansion, perhaps after making their peace with somewhat higher interest rates and more elevated volatility.

(Dow futures were rebounding Monday, pointing to a 1 percent higher open.)

So what exactly happened?

As January was winding down, the bounty of good economic news, tax-cut enthusiasm, rising profit forecasts and belated public embrace of stocks left the market dangerously stretched to the upside.

Quite simply, stocks were expensive and people owned enough of them — in fact, maybe more than enough. For those who evaluate the market across various fundamental, technical and sentiment measures, the main thing stocks had going for them by January was unrelenting momentum and refusal to succumb even to routine pullbacks. Then that fell away.

The first ripple lower coincided with a gathering storyline about inflation, rising rates and economic overheating from fiscal largesse hitting a fully employed economy. Outgoing Federal Reserve chair Janet Yellen and other Fed officials effectively said a stock-market tailspin was of little concern to them, absent real economy effects that they did't expect.

The fact that Treasury yields were sticky near their highs during the equity sell-off meant that yield-centric defensive sectors such as utilities and consumer staples couldn't rally to buffer the weakness as they've done in recent years in an elegant, soothing sector rotation.

The swiftness and severity of the decline upended various strategies built for a calm, strong equity tape with suppressed bond yields, such as the selling of equity-market volatility (which essentially means selling disaster insurance to others at cheap prices). These strategies are in disarray and their ongoing capacity to roil markets in coming weeks is hard to handicap — but likely diminished compared with last week.

Rare in its rapid descent

Before this month, a drop of 10 percent from an all-time high in less than two weeks hadn't happened since 1928. A look at other, similar sudden market breaks from history shows a relatively encouraging pattern of a fairly quick recovery. One has to look back to 1955, 1980 and 1986. There are also some echoes of the late-'90s gut checks, the 1997 Asian currency crisis and the 1998 Long-Term Capital Management meltdown.

Bespoke Investment Group points out the S&P 500 had only gone from "extremely overbought" to "extremely oversold" (as statistically defined) in less than two weeks 21 times before this correction. Most instances were not within, or at the start of, bear markets. Forward returns thereafter were pretty good, on average, though some continued turbulence wasn't uncommon.

For what it's worth, bull markets tend not to end for good the way that "melt-up" into January did, as discussed here in mid-January. Urban Carmel, a veteran trader and market blogger, has a helpful roundup of the fundamental, technical and sentiment situation here.

His central takeaway: "That equities have quickly recovered from previous swift falls that started from a high should not be a surprise. Strong uptrends carry momentum that typically weakens before failing completely. The implication, however, is that for the first time since early 2016, the trend in equities is on watch. A recovery to prior highs followed by more volatility creates the sawtooth pattern that is most often found at important tops."

While on watch, it's crucial to track macro signals outside of stocks. For now, it's a net positive that the credit markets are not showing the sort of stress that would imply economic or liquidity problems — as happened in 2015, when a similar "volatility shock" and quant-fund meltdown segued into a macro scare as junk bonds, oil and global earnings were hit hard.

It would be unusual for stocks to go down a lot more, and stay down, given the path of corporate profits this year. Here, FactSet shows the trajectory of 2018 earnings forecasts steeply rising (largely due to tax-cut and weak-dollar effects, but still).

It's not unprecedented for stocks to struggle even as corporate earnings surge. This happened in 2011 and in 1994, when the broad indexes were flattish, with many sectors struggling and the market sustaining whippy volatility and macro scares along the way.

Legions of Wall Street strategists last week were out declaring "the fundamentals have not changed." This is not wrong, exactly, but also not the real point.

Not broken, just bent

This is a valuation, sentiment and investor-positioning reset, with an exacerbating "X-factor" of a crowded volatility-trade unwind.

The market was likely overpaying for good fundamentals two weeks ago, and investors were giddily extrapolating the good news too far, encouraged by extraordinarily loose financial conditions. It's now figuring out the right price to place on profits juiced and front-loaded by tax cuts in a world where Main Street might take more of the rewards of a humming economy than Wall Street.

A slightly less perfect setup, perhaps. But for now, it appears to mean this bull market is not broken, just bent.