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 For much of the rally, corrections – declines of 10 percent - have
been brief, as investors were always ready to jump in, betting that
low interest rates and a slow-but-steady economic expansion would
boost shares. Stock repurchases and high dividends supported equity
investments as well.
And while the market had slipped a bit from its peak in late May,
few seemed worried, even if buying enthusiasm had slipped.
That changed about a week ago with the selloff out of China that hit
markets worldwide, caused commodity prices to plunge and raised
doubts about earnings and growth while also calling into question
whether central-bank support could make a difference after years of
loose policy.
"I think there is a high risk of a bear market," said Mike O'Rourke,
chief market strategist at Jones Trading. "All these things that
were tailwinds for recovery have turned into headwinds."
U.S. markets rebounded on Wednesday, providing a respite for
investors. With the S&P 500's 3.9 percent gain to 1,940.51, it means
that for the market to enter bear-market territory – a 20 percent
decline from its closing peak - it would need to fall more than 200
points, to about 1704.
Still, the list of concerns is long, and begins with the slowdown in
China's economy, now believed to be expanding at its most tepid pace
in two decades. At the same time, the Federal Reserve may be on the
cusp of raising interest rates for the first time in nearly a
decade.
Higher rates and a less robust China could hinder the sluggish
growth of the U.S. economy and strengthen the dollar, further eating
into weak earnings expectations for the second quarter. The focus on
those headwinds, along with market valuations that still strike some
as expensive, has sapped buying interest.
The most sign of the change in sentiment was seen Tuesday, when the
S&P 500 closed 4 percent lower than its session highs, causing some
to realize that buyers are currently not taking advantage of the
dips with more purchases.
"When you close at the low of the day, it's an important signal,"
said Jack Ablin, chief investment officer at BMO Private Bank in
Chicago. "The economy is solid but the financial markets are ripe
for some kind of correction."
The sharp declines have also resulted in a big move higher in
volatility. On Monday, the CBOE Volatility Index <.VIX>, the
market's favored barometer of investor anxiety, shot up 25 points to
53.29, highest since January 2009. While it has receded since then,
it closed Wednesday at 30.32. A reading greater than 30 is
associated with periods of greater worry.
"It's running at sort of crisis level values," said Andrew
Wilkinson, chief market strategist at Interactive Brokers LLC in
Greenwich, Connecticut.
Investors have responded to the gyrations by adding to protection
against losses. The number of bearish put options trading, compared
with bullish call options, on all U.S-listed stocks and indexes is
at its highest level in nearly four years.
"My sense is that people are hedging entire portfolios particularly
in light of the jump in the volatility index, which tells you that
premiums are being driven by fear,” Wilkinson said.
The 10-day moving average of overall put volume relative to call
volume hit 1.1 on Tuesday, the highest since October 2011, according
to options analytics firm Trade Alert data.
Volume in the iPath S&P 500 VIX Short-Term Futures exchange-traded
note, which gives investors exposure to VIX futures contracts, saw
its four biggest days of activity between Friday and Wednesday in
its history, with more than 758 million shares combined on those
days.
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BREAKDOWN
To be sure, some strategists say the recent volatility in the stock
market is overdue and should be expected at a time when the Federal
Reserve is moving closer to raising interest rates.
The S&P 500 last dropped by 10 percent or more in August 2011, a
four-year span six times longer than average number of trading days
between such declines, said Bill Stone, chief investment officer at
PNC Asset Management Group. That long interval led investors to
become overconfident and pushed stock valuations too high, he said.
Stone said he does not expect the index to fall by the 20 percent
that defines a bear market.
"It's hard to feel really good while the markets are so volatile but
people will look back and say that this cleared the decks and took
us from overbought conditions to oversold," Stone said.
An improving U.S. housing market, strong employment numbers and the
possibility of improved margins because of the declining value of
the yuan could all help send corporate results higher than analysts
expect in the next earnings season, he said.
As of yet, estimates have not declined by much. S&P per-share
earnings for the next 12 months are expected to come in at $123.84,
putting a price-to-earnings ratio of 15.1 on the S&P, according to
Thomson Reuters data, broadly in line with the historic average.
Earnings estimates overall are down 1 percent from one month ago,
when the P/E was 16.8, but worries about growth could force analysts
to cut estimates, making it possible that prices would have to fall
further for valuations to adjust. Compared to sales, Ablin said he
believes stocks are overvalued by 10 to 15 percent.
BORN TO RUN
Before Wednesday's gains, the S&P 500 had fallen by 1 percent or
more for four consecutive trading days, the longest consecutive
streak of losses of that size since the bear market low in March
2009, said Jason Goepfert of Sundial Capital Research. Yet five of
the seven streaks of losses of that size over the last 50 years have
marked a market low, with the market averaging a gain of 24 percent
over the following 12 months.
The volatility of the market over the coming weeks will likely
influence whether the Fed ultimately decides to raise rates at its
September meeting, said Jim McDonald, chief investment strategist at
Northern Trust in Chicago. Yet even if the economic data remains
strong, he doesn't see a rebound just yet.
"We shouldn’t expect the market to start marching upwards from
here," he said. "It needs some time to heal."
(Reporting by David Randall and Saqib Ahmed, additional reporting by
Rodrigo Campos. Editing by David Gaffen and John Pickering)
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