The market's slide is probably temporary as valuation, investor sentiment undergo a great reset

Published Sat, Oct 2 20218:39 AM EDT

September's stock-market slide will probably prove to be part of a temporary shakeout, with a slimmer chance it's the beginning of a more important breakdown. What's sure, though, is that it reflects a significant bull-market reset that is undoing isolated excesses, pricing in a more grounded economic reality and helpfully lowering investor expectations. The 5.2% decline in the S & P 500 from the Sept. 2 record high through the end of the month Thursday – narrowed by Friday's 1.2% bounce – was the headline index succumbing to an undertow that had been dragging on the market since June, when cyclical and "reopening" stocks peaked. Through the July and August upward grind in the S & P , the common complaint was that market breadth was lacking, the rally a matter of the select few big growth stocks trudging higher. Now the index has "caught down" to the typical stock, the S & P 500's year-to-date gain now perfectly aligned with that of the median stock as gauged by equal-weighted Russell 1000 – up an even 16%. Both those indexes are 3.5% to 4% beneath their peak, but most stocks have absorbed far more punishment. A third of S & P 500 entered Friday at least 15% off its high, and on the Nasdaq half of all issues have dropped 20% or more. The market has been supported since the spring of 2020 by steadily rising corporate-earnings forecasts, with the S & P often running a bit ahead of the consensus profit target. While year-ahead estimates have flattened out a bit, the recent setback in stocks has arguably begun rebuilding a valuation cushion, making the price/earnings relationship seem a bit less aggressive, now at 20-times expected profits over the next 12 months. Not cheap but less demanding than it's been for a year and a half. (Source: Deutsche Bank) Major win streaks reset The market has also reset the clock to zero after a couple of prolonged win streaks. September ended both the S & P's string of up months at seven, and one of the index's dozen longest stretches ever without at least a 5% pullback. The prior five seven-month win streaks did not end at a major market peak, but rather within ongoing bull markets, including in mid-2013 and late 2009. And after the first 5% drop ending the longest streaks without one, the market went on to struggle a bit longer but never underwent anything more than a fairly normal correction. Ned Davis Research notes that all of the pullbacks eventually got to at least an 8% decline, with the next S & P 500 new high between two and 12 months later. It's a similar story when checking back at periods matching the present setup, in terms of a down September with the S & P still up at least 10% for the year. The pattern was a higher-than-average chance of further downside into October, but on average rebounds to post a positive fourth quarter as a whole, according to Bespoke Investment Group. The mood and risk exposure of investors has likewise rest from less optimism and aggression. In the same week the American Association of Individual Investors survey showed bearish respondents climbed above 40% for the first time in a year, the equity exposure among the professional advisors in the National Association of Active Investment Managers poll dropped toward 50%, a multi-month low. So if the main knocks on the market a month ago were that the top-heavy S & P 500 was diverging from the majority of stocks, that the upside path had been too steady and easy to escape downside mean-reversion soon and that investors were complacent and overconfident, the past several weeks would seem to have addressed them all. Missing dip buyers That's not to suggest that the market's adjustment has been purely mechanical and benign, or that it's necessarily over. The character of the tape has changed in a way that has shifted the burden of proof in the near term over to the bulls. After going ten months without spending more than a day under its 50-day moving average, the S & P has spent the past two weeks beneath it. The urgency of dip buyers has apparently dissipated for now. Late-day weakness has been the rule lately, in a switch from most of this year. ETF inflows have not emerged after big one-day drops in the indexes the way they had in prior months. And retail options-trading volumes, a major source of buying energy since the March 2020 market bottom, has ebbed as a proportion of all option turnover, as JP Morgan shows here. It's not hard to come up with reasons why investor conviction has waned. Aside from the less-rewarding technical action, third-quarter economic growth is lower and inflation staying higher than generally expected a few months ago. While the most economically sensitive parts of the market took account of that slowdown from June through August with steady underperformance, third-quarter earnings forecasts are being trimmed and the supply-chain frictions might be reaching their saturation point as a front-and-center worry point. Clearly, the policy front seems less friendly, with a clogged path to the infrastructure and social-spending packages in Congress and the Federal Reserve looking to hasten the wind-down of its bond-buying program. Supportive factors It's a noisy environment for sure, but that doesn't change a few supportive factors for stocks: Rising Treasury yields and well-behaved credit markets argue that the economic-recovery forces still hold sway. The economic data has again begun outperforming economist forecasts after a couple of months of disappointing. Cyclical bellwethers such as small-cap, bank, energy and auto stocks have been sideways or better even as the main indexes have rolled over, again suggesting more of a messy, fitful rotation underway rather than outright macro weakness being priced. And, for what it's worth, it would be fairly unusual for the market high in an otherwise strong year to be as early as Sept. 2, unless the market was contending with both an at-risk economic expansion and a Fed on a determined tightening path. This was roughly the setup in 2015 and 2018. The superstitious might wonder if such a treacherous mix recurs every three years. For now, those conditions aren't fully in place and the market has reset itself by consolidating and cooling off, with investors more wary but also aware that year-end rallies are often forged in the heat of September and October mini-meltdowns.

Traders work on the floor of the New York Stock Exchange (NYSE) on September 30, 2021 in New York City.

Spencer Platt | Getty Images

September's stock-market slide will probably prove to be part of a temporary shakeout, with a slimmer chance it's the beginning of a more important breakdown.