The market has been here before, and not long ago, the S & P 500 index undergoing a 5% setback after a nice rally to record highs, a shakeout that is moderating valuations and dousing investor overconfidence. The parts of this spot that look familiar are comforting: the technical conditions getting ripe for some kind of strong relief bounce in coming days and the market's palpitations at odds with an underlying economic heartbeat remains steady and strong. Yet the elements that appear different from the prior 5% pullback that started in early September — and the one before that in the first quarter of the year — are a bit less comforting and suggest a plausible but narrower path higher than investors have enjoyed most of the year. Wall Street has dealt with the emergence and global spread of a new Covid variant before, the delta wave — but not at a time when the Federal Reserve chair had pivoted from maximizing employment to signaling more vigilance on inflation, and when the bond market was pricing in potential rate hikes next year that will restrain growth along with inflation. This market has handled cascades of weakness in the more speculative momentum stocks in the past ten months — the gut checks in cloud-software, SPACs and recent IPOs — but not with the intensity of the recent purge, which has taken on the characteristics of forced liquidations by trapped institutions. Third of the benchmark off 15% A tricky moment then, but one preceded by a tremendous volume of selling that has both done some technical damage to the average stock while also starting to flash signals that it's getting so bad, it's good. A third of the S & P 500 is off at least 15% from its high, with the index itself off just 5%. Just over half of the index members are above their 200-day average price, a skimpy reading with the indexes so recently at a record, which tells of a mercilessly selective market but also lots of catch-up potential. Nearly one in eight Nasdaq-listed stocks made a new 52-week low in each of the past two trading sessions, evidence that broad precincts of the market are getting fairly washed out. Anxiety has displaced avarice rather quickly. The CNN Money Fear & Greed Index — a composite of market-based indicators that gauge risk appetite across stocks, bonds and options — dropped to its 2021 lows, previously seen as prior equity pullbacks were culminating. It has only tended to plunge below this when the market is in near-crash mode, such as December 2018 and March 2020. A month ago, it was suggested here that the market needed to cool off to relieve some overcooked risk-chasing behavior and over-excited investor expectations, observing that "things are getting a bit giddy, many stocks being stretched far out on unstable limbs, the bulls having it a bit too easy." 'Fear of staying in' In just a few weeks, the situation has swung almost 180 degrees, with an urgent "fear of staying in" the market supplanting the "fear of missing out" on gains. This has taken the form of a brutal, rolling purge of crowded hedge-fund holdings (financial-technology and software) exacerbated by capitulation in an array of once-buzzy high-concept companies (e-commerce apps, sports-betting plays) and stay-at-home proxies. After a week in which the S & P 500 lost 1.2% with frequent whipsaws and air pockets, Deutsche Bank strategists noted, "The equity selloff since last Friday remains modest so far, in keeping with regular 3-5% pullbacks that have occurred every 2-3 months historically. However, this was accompanied by the sharpest weekly decline in equity positioning since the collapse back in March 2020 at the beginning of the pandemic." Overall equity exposure across investor categories went from near the top of its long-term range to the lowest reading of the year, though this places it squarely neutral in historical terms as opposed to deeply negative. Similarly, demand for protective put options rushed from some of the lowest levels in 20 years to among the highest. This leaves professional-investor positioning out of step with what would be typical with macroeconomic conditions as solid as they have been lately. This is all a comfort to bullish investors and argues in favor of stocks finding their footing fairly soon. The S & P 500 late last week was fitfully churning near its 50-day average and above the 100-day, the tactical zone where it bottomed in October. This is also roughly halfway between that Oct. 4 low under 4300 and the record high a bit above 4700, arguably a reasonable spot for the tape to gain some traction. Market stress Yet the urgent flight by investors away from equities is itself reason to remain mindful of possible further instability, with signs of indiscriminate deleveraging raising market-stress indicators. Through Friday afternoon the CBOE S & P 500 Volatility Index ratcheted up to 35 and — more alarming to some traders — the VIX futures pricing array inverted, with near-term December VIX trading above January, an anomalous and potentially hazardous arrangement. While such a so-called backwardation can occur as a selloff crescendos and underwater investors are forcibly blown out, it's hard to know in advance whether the market's pricing of a near-term volatility storm is predictive or precautionary, or when the purge of distressed players is through and positioning cleaned up. Along the way, the heavy selling across the majority of stocks has drained some valuation excesses, especially in the typical stock rather than the top-heavy S & P 500. This comparison shows the equal-weighted version of the S & P with a forward P/E lower than it was in early 2018 and four multiple points below the standard index. Not cheap but a less-demanding hurdle for capturing future returns. In general terms, when overall earnings are expanding – so far consensus for 2022 is for 8.8% growth – stocks tend not to suffer deep and lasting downturns. Even if the Fed is on a path toward tightening, no policy move is likely unless the economy and markets are ready and even asking for it. The first hike tends not to end a bull market. Year-end tailwinds? It's been noted here and elsewhere in recent months that years when the S & P 500 has been strong heading into November typically add to gains, and that fourth-quarter seasonal tailwinds tend to blow unless financial conditions are tightening. Credit spreads have widened somewhat from historically tight levels, and the Treasury yield curve has flattened quite a bit, both evidence of less loose, if not truly tight, conditions in a fast-maturing cycle. And December markets suffer from lower liquidity, sometimes a self-reinforcing dynamic as higher volatility directly keeps dealers and systematic hedge funds from adding more trading capital into the mix. The confluence of the information deficit tied to the impact of the omicron variant and Fed chair Jerome Powell endorsing a quicker wind-down of the Fed's bond-buying program has understandably given investors pause and interrupted the market's well-practiced rotational act of alternating strength in cyclical/reopening sectors and defensive/growth groups. Are markets perhaps over-reacting to omicron after generally underplaying the initial Covid outbreak and the rise of the delta variant? It's plausible but unknowable yet. Plenty to ponder and not enough to be certain of. Yet for those would-be dip buyers ready to take a swing, the count has moved in their favor even if the next delivery isn't as fat a pitch as bulls have seen before.
Traders work on the floor of the New York Stock Exchange (NYSE) on December 02, 2021 in New York City.
Spencer Platt | Getty Images
The market has been here before, and not long ago, the S&P 500 index undergoing a 5% setback after a nice rally to record highs, a shakeout that is moderating valuations and dousing investor overconfidence.