One of the most powerful trends supporting the U.S. equity market seems to have come to a quiet end.
Buying the dip, or investors using share-price declines as an opportunity to add to their positions, has waned in popularity over the past several weeks. In contrast to 2017, when major indexes went an unprecedented length of time without a pullback of even 3%, let alone 5% — both of which are extremely common, historically speaking — stocks are currently in their longest stretch in correction territory in a decade.
The unwillingness of investors to jump into the market could be a suggestion that they see few bargains out there, even at a time of steady economic growth and corporate profits growing at their fastest clip in years. Trading volumes have been anemic — itself a potential red flag — and while corporate results have largely come in ahead of analyst forecasts this earnings season, investors have shown little inclination to reward strong results. Yet they haven’t hesitated to punish stocks when there’s any hint of earnings weakness.
The earnings-related volatility, which is elevated compared with other seasons, is just the latest example of volatility in the equities market this year. The sharp gyrations really began in early February, when both the Dow Jones Industrial Average (.DJI) and the S&P 500 (.SPX) swiftly fell 10% from record levels, putting the two in correction territory. The catalyst for the decline was concerns over inflation, and while equities partially recovered off that fall, they were then hit by concerns over trade policy, weakness in large-capitalization internet stocks, and rising bond yields, among other factors. This sparked another series of dips, one that investors have shown limited interest in buying.
“What really killed the ‘buy the dip’ mentality was the second pullback we saw. That’s when it all changed, and people realized we weren’t looking at a temporary period of high volatility, but a new volatility regime,” said Randy Frederick, vice president of trading and derivatives for Charles Schwab.
“They might have gotten burned buying the correction, and now they’re more hesitant. Volatility has been sustained for weeks now, and it’s become too darn stressful to think about jumping in. People are trickling out of the market.”
The lack of volatility or pullbacks seen over 2017 was atypical, and it was largely attributable to a few factors that provided an undergirding to equities overall. Now, however, those factors have either waned or reversed.
A key support last year was optimism that President Donald Trump would sign a tax-reform bill into law. He did so in December, providing an immediate lift to corporate profit rates. This fueled equity gains in early 2018, but the impact is seen as largely priced into shares now, to the point where earnings growth is seen as having peaked in the first quarter.
Another factor was low bond yields, as measured by the 10-year U.S. Treasury note, where the yield swung in a range of roughly 2.1% and 2.6% throughout 2017. This year, however, the yield cracked 3% and reached multiyear highs, raising questions about both corporate borrowing costs and the relative attractiveness of stocks compared with bonds. (The rise in yields means that bonds are falling, as bond yields and prices move inversely to each other.)
Rising yields are related to another key factor that has been supporting Wall Street for years but which is also coming to an end: the Federal Reserve. In addition to raising interest rates — another potential headwind for equities — the Fed is reducing the size of its balance sheet. The central bank’s bond-buying program, which ballooned its balance sheet to nearly $4.5 trillion, helped push down interest rates and made stocks look all the more attractive relative to fixed income. Now, with that balance sheet being unwound at a pace $10 billion a month (the pace will eventually accelerate to $50 billion a month), this steady drumbeat of equity support will fade.
“We don’t have the Fed at our backs like we had for several years, which means the ‘buy the dip’ mentality is waning. You have to be more wary than you used to be, and reevaluate how attractive stocks look relative to other assets,” said Michael Mullaney, director of global market research at Boston Partners.
“At the same time, bonds have been behaving badly. Both stocks and bonds are going down, so people are getting nervous about markets in general. The question is, what do you do in a market like that? You don’t buy the dip. You hide in cash.”
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