Stock decline may signal turning point
Experts unsure whether 6.6 percent drop a blip or start of a bear market
In a span of six treacherous days on Wall Street, the mood of the stock market has turned from giddy optimism to gloomy pessimism.
Pinpointing major shifts in markets is an inexact science. But some Wall Street pros say the current one has reached a turning point, as the low interest rates that powered stocks higher over the last decade give way to higher borrowing costs and heightened risks.
A swift 1,776 point, or 6.6 percent, dive in the Dow Jones industrial average just a week after it hit a record high shows just how edgy and uncertain the investing environment has become.
Investors, who a week ago were talking up the market’s prospects thanks to a strengthening economy, are now noticing a worrisome shift in its behavior.
“Has the market hit an inflection point? I think it has,” says Jim Paulsen, chief investment strategist at The Leuthold Group, a Minneapolis-based money-management firm.
This downturn, he predicts, will likely be more severe than the 10.2 percent drop the market suffered in February. But he’s still not sold on the idea that the break will lead to a bear market, or 20 percent drop, from the market’s recent high.
The debate about whether the market vibe has flipped from bullish to bearish centers on a few key issues: They include risks to the economy caused by a rise in interest rates; trade frictions with China; the recent drubbing of technology stocks; and increasingly high investor expectations that could lead to easy disappointment.
Some Wall Street pros, including Amanda Agati, co-chief investment strategist at PNC Financial Services Group, say the recent carnage on Wall Street was long overdue and is a “short-term blip” that will settle down
quickly. She stresses that the U.S. economy remains strong and the threat of recession is low. The mood of investors will brighten, she predicts, when companies start reporting their third-quarter results.
“I think earnings will be really strong and provide an underlying support for the market and be a positive catalyst,” she says. The current downdraft has a different feel than the selloff in February, she adds. That drop was caused by too many investors making a big bet on the stock market remaining calm, which backfired when volatility roared back, catching them on the wrong side of the trade.
Still, others worry that the market is entering a more difficult phase, one that will have a much different, more challenging feel to it.
So what changed in the past week that has investors so worried?
❚ Interest rate angst: The biggest change has been an acknowledgement that rising interest rates could cool a strong U.S. economy and also put a dent in corporate earnings. The combination of the Federal Reserve hiking short-term rates last month and another increase expected in December, coupled with a spike in the 10-year U.S. government bond to a seven-year high has made stocks less attractive compared with lower-risk bonds.
Low rates and cheap money resulted in a flood of money into stocks in recent years, as people searched for bigger returns.
But now financial conditions are getting tighter.
“The wave of money that was moving into the market is now reversing,” says Savita Subramanian, head of U.S. equity strategy at Bank of America Merrill Lynch. “As liquidity is withdrawn from the market, it amplifies market volatility” and price swings.
Higher borrowing costs also make it tougher for Americans to afford houses and buy cars on credit, analysts say.
❚ Trade war reality: The protectionist trade policies of President Donald Trump and his administration’s tariff fight with China have upended the long era of free trade. That has unintended consequences, ranging from a disruption in global supply chains for technology to higher costs for businesses that either have to eat the costs or pass them along to shoppers through higher prices.
“The trade war is no longer abstract economics, we’re now starting to see it is real-world stuff showing up in the earnings results of companies,” says Hugh Johnson, chairman and chief investment officer at Hugh Johnson Advisors in Albany, New York.
He notes that companies ranging from luxury retailer Tiffany to auto parts maker Delphi Technologies have warned that their profits will take a hit due to cost pressures related to tariffs.
❚ Fading tech stocks: After years of leading the market higher, fast-growing and innovative tech companies like Netflix and Apple have come under intense pressure in the recent sell-off, signaling that investors are becoming more risk averse and taking a more defensive stance.
“The sell-off has attacked the leadership of the market, and that’s a significant change,” says Paulsen. “These are the names that most people own and feel really good about. You are kind of punching investors in the gut where it hurts.”
The tech stock drubbing, which also has been driven by increasing fears of regulatory scrutiny from government amid privacy breaches, shows “investors are getting a bit more defensive,” Agati says.
❚ Expectations are high ... too high:
Consumer confidence is at an 18-year high. And small-business optimism is at its highest level since 1983. And why not? The economy’s 4.2 percent growth in the second quarter was the fastest in four years, and the nation’s jobless rate is near a 50-year low of 3.7 percent.
The good times might lift investor expectations too high, which raises the risk that incoming good news on earnings or the economy won’t be good enough. “That is a higher-risk, lower-reward market,” says Paulsen.
Indeed, all that confidence can lead to complacency and dangerous risktaking that can lead to bad outcomes, he adds.
“Confidence reflects greed,” Paulsen says. “It reflects complacency. It leads to behavior that lends itself to people getting out over their skis, whether borrowing too much money or getting too exposed to risky parts of the market or piling into the popular stocks that are working.”