Markets

If the market's 'free pass' is over, news must be more than just 'less bad' for rally to resume

Key Points
  • The market had a free pass for a while that allowed investors to rebuild equity exposure without needing much more than "less bad" news and revived credit markets.
  • That ended with last week's sell-off.
  • The gut check also came as the best-ever 11-week rally was about due to backslide or at least flatten out.
  • The VIX back above 40, extreme bouts of style rotation, fervid speculation in volatile retail-centric stocks, the drop in Treasury yields back into their springtime range and a backup in credit spreads all should leave investors on guard for a change in market character.

Has Wall Street's free pass expired?

That's one way to interpret last week's sharp setback in stocks, which punctuated a powerful rally built during a period when expectations for the economy were minimal and the pessimistic arguments on a Covid second wave, fiscal-policy shortfalls and electoral politics could not soon be proven.

This free pass allowed investors to rebuild equity exposure rapidly from depressed levels without needing much more than "less bad" news and revived credit markets.

Last week, though, the Federal Reserve's cautious longer-term outlook on the economy and a steady rise in Covid cases in several hot-weather "reopened" states served as plausible excuses for Thursday's near-6% selloff in the S&P 500 and jump in the CBOE Volatility Index.

While the threshold for re-imposing stay-at-home orders appears quite high in most of the country and is not favored in public-opinion polls, the climb in coronavirus hospitalizations has complicated the belief feeding into share prices that momentum toward a swift, smooth and strong reopening process was irresistible.

There has not yet been a reported surge in infections two weeks after mass protests began in many U.S. cities, which is certainly a plus. But the persistent rise in cases forced investors to ask tougher questions about how forceful the travel and consumer comeback will be this summer and into the fall.

Covid, fiscal flux and the election

The Fed's message of a long trudge out of a deep economic hole comes just over six weeks before extended unemployment benefits are set to expire, and movement toward another federal fiscal support package has flagged. The stock market has behaved at times as if it sees existing fiscal help to be enough to bridge consumers through the worst of this downturn, but this notion hasn't been tested.

 As for the election prospects, it's tough to tease out how much a swing factor the they are on stocks just yet.

Stifel strategist Barry Bannister last week cut his S&P 500 target to 3100 in December from an August target of 3250, in part in response to Democrat Joe Biden's recent rise in the polls and betting markets. More fully, the move comes in light of the following: "(1) Shifting 2020 election trends may threaten the 2017 corporate tax cuts and deregulatory environment, (2) While the Fed pledged Jun-10 to continue the current easing the Fed did not increase the pace of easing, which is an incremental tightening, and (3) a double-dip recession is possible if media and government continue to portray the SARS-Cov2 virus as a modern-day plague in a spectacle that we believe has become politicized."

It's worth noting that the S&P 500 kept climbing for weeks along with Biden's poll tally until a few days ago. And the market often doesn't always quite know what it ultimately will want out of an election. In 2016, stocks tended to rally along with Hillary Clinton's prospects, then of course took flight following President Trump's win. The S&P had a nasty pullback shortly after President Obama's 2012 re-election and then went on to have one of its best years ever in 2013.

Still, Wall Street can reliably be trusted to begin fixating on "election risks" every fourth summer, so perhaps they will act as a restraint or a prompt for some volatility in the months to come.

Or tape just stretched?

Of course, none of these overhanging issues – Covid, fiscal flux and the campaign - are in themselves new or particularly surprising. Perhaps the market's sudden switchback, with these stories in focus, said more about the indexes having become overheated, as noted here last week, as the tape stretched to a tenuous overbought state and trader sentiment grew aggressively optimistic.

The S&P's 5.9% drop Thursday and slight, tentative Friday bounce came with a ramp in the VIX above 40 again, puncturing the rally's air of imperturbability, while helpfully draining away some of the frothy overconfidence of short-term traders.

The gut check also came as the best-ever 11-week rally was about due to backslide or at least flatten out. This chart from SunTrust's Keith Lerner plots the rebound rally against other recoveries from important market bottoms in history, suggesting it needs time to settle back and consolidate the gains, at minimum.

There's no doubt the rapid retreat and even more extreme swings in subsegments of the market – the Russell 100 Value index fell 10% Tuesday to Thursday – might have touched off a choppier market phase as the news flow seems a bit less "heads I win, tails you lose" for the bulls.

Still, the pullback is so far well within the routine zone, and Friday the S&P absorbed a midday selling squall that briefly took it negative only to recoup a quarter of Thursday's loss. Several extraordinary technical readings of the breadth, persistence and magnitude of the rally in recent weeks won the bulls some credibility not fully depleted by the steep one-day sell-off.

Those rare technical readings placed the rally among only a handful of historical rebounds off key market lows, with unusually positive implications for returns in the months ahead – though not necessarily in the short term.

The S&P, after shedding about a fifth of the total gain from the March 23 low, has made the push higher in June appear an upside overshoot, and is now hashing around its 200-day average. With another 3% drop would be testing the breakout from the month-long range three weeks ago, and no doubt further declines would be shadowed by enough cautionary headlines on Covid or the economy's very real challenges to make them feel ominous. 

The VIX's brief foray above 40, extreme bouts of style rotation, fervid speculation in volatile retail-centric stocks, the drop in Treasury yields back into their springtime range and a backup in credit spreads all should leave investors on guard for a possible change in market character.

This could involve further tests of the vaunted resilience this market displayed for months, while investors were proudly carrying that free pass whose expiration date is not clearly marked.