Rout Repeated: Second Late Dive of Week Sends Stocks Into Correction Mode

The second 1,000-point dive of the week for the Dow Jones Industrial Average ($DJI) has stocks in correction mode.

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(Thursday Market Close) Heavy selling picked up late in Thursday’s session, sending stocks to new lows for the week and into correction territory as interest rate fears continued to haunt the market. It was the second 1,000-point drop this week for the Dow Jones Industrial Average ($DJI).

The last hour was really harsh, as it looked like some investors might be fearful of holding long positions into the closing bell. The $DJI cratered, falling more than 300 additional points in the final 35 minutes to post a four-digit loss for the second day in the last four. Stocks have now fallen four of the last five sessions and are down 10% from the Jan. 26 high. A 10% drop is typically considered the definition of a market correction.

Most of the major indices finished down 3% to 4% on the day, and volatility shot back up above 35 for the VIX. No relief came from the fixed income complex, where 10-year yields settled in at around 2.85% for much of the afternoon, near the four-year highs of earlier this week. The “flight to safety” money doesn’t seem to be going into bonds, but instead might be ending up in the utilities sector, which fell far less sharply than the rest of the market.

Every sector other than utilities and consumer staples fell more than 2%, with the loss leaders including consumer discretionary, financials, industrials, and info tech. These are the kind of stocks people tend to buy when they’re optimistic about the economy and sell when they’re concerned.

There’s no one explanation for this bout of stock market weakness, though it’s disheartening for many after Tuesday’s quick rebound. You could conceivably look at lots of factors and never settle on one benchmark. We’ve covered a lot of them here. They possibly include investors unwinding the short-volatility/long stocks trade that had been popular for months, wages rising 2.9% and raising inflation concerns, proposed deficit spending by Congress that could conceivably inject more debt into the market and raise borrowing costs, and the recent quick jump in Treasury yields to above last year’s highs. Don’t discount the “pent up” selling demand that may have developed with the great rally in 2017 and people not selling into a big rally.

Some think the markets were simply overbought and due for a decline, but few if anyone thought it would happen as quickly as we’ve seen. The sharpness of this downturn could be partly related to program trading that occurs when stock prices fall below certain technical levels. That tends to quickly accelerate losses.

There’s also an emotional content to all this. Arguably, many people had been lulled by the low volatility of the last year and a half. Stocks went months without a 1% daily decline or advance, and just steadily moved upward. Once things went south, there may have been a sharper reaction than normal, like the shock of being woken up from a deep sleep. Now, with volatility so high, potential buyers might not feel comfortable getting in, even though company news continues to look pretty solid.

Another possible reason for the lack of buyers could be that it’s earnings season, and many companies have rules preventing them from buying back their own stock within a certain timeframe around their report dates. This probably isn’t a big factor, but it could be keeping some “buyers of last resort” out of the market.

The big question to ponder now — and investors seem to be hashing this out as stocks continue to plunge — is whether these high multiples can remain realistic if interest rates end up climbing more. Many investors have seemingly grown comfortable with price-to-earnings multiples of 18 or more, but as one analyst told CNBC on Thursday, stock multiples averaged just 15.5 back in the day when 10-year yields were 5%. Investors tend to value stocks a bit lower when companies are constrained by higher borrowing costs. Though a return to the days of 5% yields seems highly unlikely now, the analyst’s point is well taken about valuations and yields.

The average S&P 500 (SPX) P/E ratio has certainly come down lately, considering the strong earnings reports from many companies, relief corporations are getting from the tax bill, and this big decline in the market.

So what should people expect going into tomorrow? As we’ve seen all week, it probably makes sense to simply expect the unexpected. Investors who don’t have strong stomachs may not want to get overly involved in this market, especially with volatility whipping around so much. Anyone investing for the short-term is heavily exposed to this volatility hurricane. The volatility is very likely to continue for two to three weeks, if history is any guide. People might want to consider being especially careful the last hour of Friday, especially because the weekend looms and that may bring extra uncertainty.

Another thing to ponder is whether Congress can come to a budget agreement tonight. Adding a government shutdown into the mix here wouldn’t seem too constructive from a market standpoint, though the last shutdown didn’t have much impact.

Long-term investors should consider checking allocations, but keep in mind it’s never a good idea to trade off of emotions. History shows that these volatile periods do hit the market time and time again, and we’re not in untrodden territory. One way for longer-term investors to reassure themselves is not to spend too much time watching each tick of the market. Simply check a few times during the day if you feel you have to, but remind yourself of the goals that keep you invested in the first place, and remember that a 2% or 3% daily decline, or even a serious market correction, could end up looking like a small bump in the road when you gaze back many years from now.

Many chart-watchers note today's move in the S&P 500 (SPX) breached the overnight low from earlier in the week. But a simple trend line (see figure 1 below) shows a line that includes bounces off of a couple of the biggest stories of 2016: The bottoming out of the crude oil market on Feb 8, 2016, and the U.S. presidential election in November of that year. Might this level hold? It's certainly an area worth watching.

SPX

FIGURE 1: TREND LINES.

The market close Thursday breached a trendline that includes the February 2016 oil low and the 2016 presidential election, two of the big market events in 2016. Data source: Standard & Poor’s. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Good Trading,
JJ
@TDAJJKinahan

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