Why Monday’s stock market rout should be a wake-up call for investors

“Investors have become overly complacent as the SPX drops its one-year downtrend resistance, just as it did in March and August,” Krinsky said in comments emailed to MarketWatch.

Other market strategists agreed with the warning, but clarified that the complacency was the result of the market’s powerful relief rally over the past six weeks.

Katie Stockton, technical strategist at Fairlead Strategies, said the latest decline in equities is “a sign that the market is fragile, and reasonably given the longevity and magnitude of the recovery.”

Prior to Monday’s session, the S&P 500 was up more than 16% from intraday lows hit on Oct. 13, the day stocks staged a historic turnaround after the release of higher-than-expected inflation data from of September.

After the release of the November jobs report on Friday, stocks fell again on Monday, with the S&P 500 and the Nasdaq Composite Index COMP,
-11.01%
recording their biggest declines since Nov. 9, according to Dow Jones Market Data. The Dow Jones Industrial Average DJIA,
-0.26%
and Russell 2000 RUT,
-2.78%
also sold strongly.

See: Here’s what history says about stock market performance in December

VIX reflects a false sense of security

Traders’ sense of security is reflected in the CBOE VIX volatility index,
+8.87%,
otherwise known as Wall Street’s “VIX” or “fear gauge,” according to Nicholas Colas, co-founder of DataTrek Research.

Often a contraindicator, the VIX hitting a level below 20 should have been a warning sign to investors that stocks were vulnerable to a sell-off, Colas told MarketWatch in an email.

“Markets were just too complacent about political uncertainty and what 2023 holds for corporate earnings. When we get below 20 VIX, it doesn’t take much for markets to rally,” said Colas said in an email.

But as Colas explained, historical patterns have helped influence the remarkably low level of the VIX over the past two weeks.

In theory, seasonal trends dictate that the rally in equities should continue through the end of the year, as MarketWatch reported last week. Stocks typically rally in December as liquidity dwindles and traders avoid opening new positions, allowing for what some on Wall Street have called a “Santa Claus rally.”

Whether that pattern holds this year is murkier.

As Colas explained in a note to clients on Monday, the main concern for equities right now is that investors have ignored the risks of further downgrades to corporate earnings forecasts, as well as other potential returns from an impending recession that many economists consider likely. .

To be sure, economic data released in recent days points to a relatively robust US economy in the fourth quarter. Jobs data released on Friday showed the US economy continued to add jobs at a solid level in November, despite reports of widespread layoffs by tech companies and banks.

The ISM barometer of service sector activity released on Monday shook the markets by coming out stronger than expected. All of this data has fueled fears that the Federal Reserve will need to proceed with even more aggressive interest rate hikes if it hopes to succeed in its battle against inflation.

More aggressive rate hikes could, in theory, trigger a “hard landing” for the economy.

Has the fall in Treasury yields reached a point of diminishing returns?

As BTIG’s Krinsky explained, a sense of complacency is not unique to stock markets. Bond yields have also fallen more than BTIG expected, he said in a recent note to clients, perhaps more than warranted by the uncertain outlook for monetary policy and the economy.

Since the yield of the 10-year Treasury note TMUBMUSD10Y,
3.584%
peaked above 4.2% in October, falling Treasury yields helped support a range of risky assets including stocks and junk bonds. The yield on the 10-year note, considered by Wall Street to be the “risk-free rate” against which stocks are valued, was just below 3.6% late Monday. Yields move inversely to bond prices

Even if yields continue to fall, the momentum in which falling Treasury yields help boost stock prices may have reached a point of diminishing returns, Krinsky explained.

“While we believe this level is holding, we wonder if a break below 3.50% would be seen as supportive for equities…[w]We have doubts,” Krinsky said in a note to clients.

Wall Street economists predict a recession will begin sometime in 2023, expectations that are supported by the sharply inverted Treasury yield curve, which is considered a reliable recession indicator.

All of this has investors keeping a close eye on US economic data for the rest of the week. A November producer price growth report due out on Friday could be another major catalyst for markets, strategists said.