Equity selloff may hint at coming volatility

4.1-per-cent decline, the S&P 500 had fallen 7.8 per cent since its Jan. 26 high before a sharp rally Tuesday pared some of those losses.

While the specific cause of Monday’s plunge may be debated for some time — as will talk about who the biggest sellers were — nervousness had been building for weeks.

“In retrospect, a pullback may have been overdue,” said Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets.

Even though sentiment has clearly become more stressed, and economic surprises have become less impressive, there are more positives than negatives for equities. Recession risk remains low, earnings trends are still strong, and this year should see a ramp-up in buybacks, M&A, capex spending and debt reduction.

“While the sharp decline in the S&P 500 on Monday was unnerving, it is important to keep in mind that these kinds of moves have tended to be buying opportunities in the post-financial crisis era,” Calvasina said.

The S&P 500 has experienced 15 one-day drops of three per cent of more since 2010. Six months later, the index was significantly higher the vast majority of the time, with a median gain of 12 per cent.

“We see the market selloff entirely disconnected from fundamentals,” said Dubravko Lakos-Bujas, U.S. equity strategist at JPMorgan. “While the sharp rise in volatility may contribute to further outflows … we believe fundamentals should ultimately prevail as companies continue to deliver double-digit earnings growth on the U.S. tax catalyst, global synchronized growth and a weaker U.S. dollar.”

Markets were clearly overbought and overdue for a correction, and recent trading suggests 2018 will be very different than 2017.

Colin Cieszynski, chief market strategist at The Fundamental Technician, noted that last year, volatility was low, and markets trended higher with few pauses or corrections. This year, the easy-money party seems to be winding down, and high valuations coupled with rising rates, may limit equity market gains.

“On the other hand, a strong economy and positive environment for earnings could help to create a floor,” Cieszynski said. “As these two forces fight it out, we could see markets move in a wide sideways trend with more volatility and less complacency for much of this year.”

It’s also important to remember what fuelled the run-up in stocks, particularly the record high for margin debt on U.S. stocks at the end of 2017.

“The sell-off in the last few days is likely to reverse this trend, and potentially accelerate it further, particularly if investors start to unwind it over concerns that we could fall further,” said Michael Hewson, chief market analyst at CMC Markets U.K.

It may sound counterintuitive, but further improvements in U.S. economic data are only amplifying investors’ concerns that a better outlook will mean accelerated interest-rate hikes from the Federal Reserve. However, if policy-makers are worried that an aggressive tightening policy could cause more problems than it is intended to solve, things could change rather quickly.

“It’s certainly been an interesting introduction for new Fed chief Jerome Powell, as he starts his tenure in the U.S. central bank hot seat,” Hewson said.