From sustained rise to sustained decline Five straight months of wins without a 2% decline were followed by three straight weeks of declines, marked by a rare six-day S&P 500 losing streak and five straight sessions last week of failed intraday rallies. As with all market spending cuts from record highs, the current 5.5% setback in the S&P 500 is accompanied by a litany of straightforward causes, ready-made excuses and plausible stories — as well as the simple “we were due.” Steady inflation and a patient Fed theme lifted the 10-year Treasury yield from 4.2% to more than 4.6% in three weeks, while expectations of a possible Fed rate cut were pushed to the outer edge of traders' time horizon. The usual monsoon headwinds that begin in April of election years and after a strong first quarter appear to have arrived on time. A geopolitical conflict that is difficult to impede never helps, even if it rarely acts as the main swing factor in the market's direction. .SPX 1Y Mountain S&P 500, 1 Year And then there was simply the high valuation and overly optimistic sentiment that built up during this five-month 28% rally that peaked at the end of March. The dominant momentum lead that took off a few weeks ago (and is shown here as it peaked) has continued to decline, a self-reinforcing process in the short term. Friday's treacherous shift from Big Tech winners to less popular value sectors (4% quasi down, 3% regional banks up) was particularly stark and appears to be part of an ongoing reversal of extreme positioning among systematic trend-following strategies. We entered 2024 with a market whose busiest stocks happen to be among the largest and most expensive in the world, and a huge premium has been placed on the perceived predictability and scarcity value of strong secular growth plays. Which takes us to the moment that appears in all pullbacks, when the question becomes whether the bar is extended enough to the downside to expect at least a strong rebound attempt. Bounce coming? Things are at least starting to move in that direction. The Nasdaq Composite Index more than doubled in a grueling test, falling nearly 8% from its recent high, falling below its old peak in November 2021, and falling below its 100-day average. In the process, the pair has become oversold, with its 14-day relative strength (a measure of price relative to the long-term trend) reading near levels seen near the previous trading lows. Some of the market breadth readings (low percentage of S&P 500 stocks above their 20-day average, for example), high put option volumes and the reversal of the Volatility Index (VIX) compared to VIX futures prices all point to a tightly coiled market vulnerable to a high-speed rally attempt. Soon. Here are caveats to note: Extreme sell-offs can always grow more extreme and extreme liquidation-type sell-offs tend to start with oversold readings, with there always being a chance that stressed trading mechanics among quantitative players will exacerbate pullbacks as they enter risk. Reduction mode. Nothing works every time, and these oversold indicators don't always come at the right time when they would be prescient. The decline so far has arguably been very orderly, at least until Friday's ferocious semi-final purge. While trader sentiment indicators have shown increased caution, most sentiment indicators are beginning to shed excessive bullishness and have not yet reached outright fear mode. Over a long period of time, about 40% of all 5% market pullbacks deepen into full 10% corrections. According to Warren Pace, co-founder of 3Fourteen Research, after the global financial crisis, “the odds of buying the dip improved by 5%.” From 2009 through 2021, buying the 5% dip was a “consistent winner.” On average, the market recovered to new highs within three months of any 5% decline and “only 35% of cases turned into 10% corrections.” However, Bice backed away from his previous bullish view of the market last Thursday, noting that the pattern may have changed again since 2022, with an upward trend in Treasury yields helping to drive equity corrections rather than the previous pattern of falling yields and acting as an indicator. Buffer as stocks decline, compounding most 5% declines into a 10% haircut. Although this is remarkably true, it is important to note that returns did not have to fall back to their pre-correction levels for stocks to catch a break. They simply needed to stop rising and stabilize somewhat. Remember, since 2022, equity investors have been worrying respectively that 10-year Treasury yields of 3%, 3.5%, 4% and now perhaps 4.6% will be kryptonite for stocks. However, under the right circumstances, once the economy showed it could absorb such returns, stocks were able to make tentative peace with them. A 10% correction from the S&P 500's high of 5,254 would pull the index below 4,800, the previous record high from early 2022, and thus would serve as a test of the first-quarter breakout. (In 2013, after the S&P 500 posted its first record high in more than five years, it doubled again to briefly test the previous record within a few months before resuming its advance.) It is useful to keep in mind that when stocks fall in price, they also go back in time, going back to an earlier point against which we can evaluate current fundamentals and ask whether anything fundamental has changed. A week ago, I noted that the S&P closed at the exact level as of March 8th — the moment of peak “we can have it all” sentiment, as Fed Chair Jerome Powell signaled interest rate cuts coming soon on March 7th and — A strong enough jobs report that day confirms economic resilience, and as buying in AI stocks picks up as a local. Last week's 3% decline took the index back to February 21, thus closing the “Nvidia gap,” as the S&P 500 rose 100 points the day after Nvidia's fourth-quarter earnings report. Nvidia shares themselves closed just above the February 22 level, although the stock's P/E fell by 2 points (29 times forward earnings now vs. 31.5 then) thanks to higher earnings expectations. Valuation Check As for the broader market, the forward multiple for the S&P 500 has fallen from 21 a month ago to 20, which is who knows what for cheap, although the equal-weighted index, as always, offers a stark discount to the premium version. Betting on the broader scope for stocks to do well compared to the dominant market cap of $1 trillion and above has been difficult, in part because of rising bond yields, which have recently stifled any expansionary action. Not only are large, cash-rich companies with long-term growth accustomed to higher financing costs, they are generally defensive against aggregate flow. Not to mention the fact that big tech companies dominate the scoreboard for earnings momentum, with significant upward earnings revisions in recent quarters. As Treasury yields took a breather on Friday from their latest project to check the economy's pain threshold, traditional energy and defense groups were the main leaders, along with the financial sector. Whether this reflects a healthy rotation in response to economic resilience or more of a erratic escape from crowded bets by fast professional players is a question to consider next week. Regional banks rose 3% on Friday, and are now four quarters away from the mini-crisis surrounding the Silicon Valley bank, with credit and deposit pressures looking manageable for now, and stocks as a group trading at just 90% of book value for the most part. They now argue that the economy is growing rapidly. Next week comes the PCE report that will set market inflation relative to the Fed's target, leaving open the possibility of another shift in a less hawkish direction now that the market has migrated to invincible consumer and higher rate assumptions. Assume a longer rate. On a trading basis, aside from oversold readings starting to accumulate, the pullback appears to have at least helped clean out strong positions and cool investor expectations just in time for a heavier week of major corporate earnings reports.
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The breakout of the market sell-off and the odds that this 5% pullback will turn into a 10% correction
