How worried should you be about a stock market selloff ?

Sparks everywhere as market dips, but conditions not yet ripe for broader conflagration

A rat-tat-tat of bad news hit stocks over the past two months, Wall Street strategists are obsessing over the odds of recession, and bears outnumber bulls in one popular investor survey. Was it merely bad luck that so many bad things happened all at once? Or is something wrong deep in the financial and economic system, that could tip the sharp selloff since late September into a bear market?

The answer may be both. Bad things happen all the time, but when there’s nothing deep to worry about, they have little wider effect. Only when there are broader problems do idiosyncratic events build into broader trouble. This selloff may blow over, but conditions are getting ripe for a bigger market disruption soon.

“Everyone always wants to know which match starts the forest fire,” says Matt King, credit strategist at Citigroup. “But the match that starts the fire is identical to all the other matches being struck all the time. What you need to do is work out if the forest is vulnerable.”

On the face of it, the U.S. market should be fine. Earnings have soared. The economy has been doing great, and economists’ forecasts for this year and next year have been upgraded slightly since the start of last month, according to daily predictions collected by Consensus Economics. Valuations are still high by historical standards, but the forward priceearnings ratio for the S&P 500—a widely used valuation tool—is back down to where it stood in the summer of 2014, after reaching a 16-year high in January.

Yet there’s no denying the bad news hammering particular companies and sectors: Microchip shares were crushed by the trade battle with China. The collapse of the bitcoin bubble added to the pain for chip makers who supply cryptocurrency “miners” with specialized gear. Oil companies have been hit hard by the slump in oil prices as supply was strong due to White House waivers for more Iranian oil sales than expected. President Trump’s friendly relations with Saudi Arabia could keep taps flowing, too.

Meanwhile, demand will also be lower if the global economy slows more than was thought. Apple and its suppliers have been hurt by lower-than-expected orders for new iPhones. General Electric is in deep trouble, and investors fear the heavily indebted American manufacturer may be downgraded to junk-bond status. China’s economy was struggling with a slowdown in lending even before the extra hit from U.S. tariffs. On top of that, the economies of Germany and Japan both shrank in the third quarter, although economists put this down to one-off effects of new auto emissions rules in Europe and natural disasters in Japan.

Each hit hurts the overall market, justifying a small drop. Taken together, they could justify a big fall, as we’ve seen.

The big threat, and thus the risk of a broader downturn, comes if markets are proving sensitive to these quirky events because they detect deeper troubles, perhaps even a common cause, as the economy approaches the end of its cycle and interest rates rise. There was a common cause to the tech-stock mayhem. But stocks with strong momentum have a tendency to get carried away—as the FANGs did, and how—then correct hard, so their fall tells us little about the future. True, in an efficient market, higher rates and bond yields ought to hurt fast-growing stocks because their value depends on future earnings; but investors had ignored rising yields for months, so the Fed is more a background worry than the trigger for the tech fall.

For the broader market, the Fed is a worry for two reasons. First, because companies have been borrowing heavily, providing dry tinder that could be ignited by a spark from policy makers. Second, because Fed rate increases make cash a much more attractive alterna- tive to stocks than it was, with the best dollar certificates of deposit now offering almost 3% with a two-year lockup, up from next to nothing a couple of years ago.

Higher rates wouldn’t matter if global economic and earnings outlooks had improved too. That was the case last year. Not anymore. Economic data in a weighted average of the 10 largest industrialized countries has come in below forecasts recently, according to Citigroup’s surprise index. U.S. companies rely on foreign sales for almost half their revenue, so a global slowdown hurts.

This all has investors moving into a new regime of lower returns, because economic and earnings growth and the housing market are all slowing while corporate leverage is high.

“It doesn’t necessarily mean we move into a bear market,” says Pascal Blanqué, chief investment officer of Paris-based fund manager Amundi. “To get a bear market/crisis you have got to have negative debt dynamics, you’ve got to have deleveraging, typically involving real estate. It’s difficult to see today that there are obvious components flashing red in the global system.”

Stocks have caught the whiff of a slowdown. The most economically sensitive sectors of industrials and consumer discretionary have fallen almost as much as technology since the start of October, with energy hit hard. Meanwhile, those with steady revenues—led by utilities, consumer staples and big pharmaceuticals—have been fine.

Investors who know the economic cycle is long in the tooth should be more sensitive to idiosyncratic bad news, as they watch for hints that the good times are over.

An alternative explanation is that investors were cocky. Tech stocks were one sign, but gauges of investor sentiment from surveys such as the weekly American Association of Individual Investors and from positioning in stock options also showed strong faith in the bull market. One note of caution: Sentiment has reversed, but investors are still far more positive than they were after the 12% fall in the S&P 500 in the summer of 2015, implying the mood could darken further.

Despite the rat-tat-tat of negativity, I’m inclined toward the positive in the short run. The froth has blown off tech stocks, the U.S. economy has yet to show any signs of trouble, and there has been a correction in the S&P.

But over the next couple of years, the forest is vulnerable to flying sparks from the trade war, while the Fed is dropping lighted matches into a leveraged economy every few months. One of these small fires will eventually spread.