Is The Stock Market Now On Thin Ice?

The sharp drop in the major averages Friday added to the week’s woes, as the Dow Industrials was down over 4% and the S&P 500 lost 3.9% for the week. All eleven S&P sectors were lower. The relentless selling was evident from the weekly NYSE A/D numbers, as only 283 stocks advanced and 2821 declined.

After last week, many investors are likely to be on edge, especially those who just got into the stock market this year. Even the Super Bowl weekend is unlikely to keep many from worrying about the stock market. It is too early to tell how many of the new buyers will exit the stock market, but I would urge them to view last week’s action from a historical perspective.

It is important to understand that the stock market’s performance in 2017 and early 2018 has not been normal. In “Bulls Stampeding – What’s Your Strategy”, I pointed out that there had been only three times, 1965, 1994 and 1996 when the S&P has gone 370 days without a meaningful correction. The winning streak in 2017 and 2018 has been much longer, so last week’s correction was not surprising.

As we started the year it seems many new investors were expecting that with the tax cut and booming economy that 2018 was going to be another buy-and-hold year. From my historical perspective, that was going to be unlikely, as I discussed in “Investing Or Trading In 2018?”. I thought 2018 was more likely to be a more volatile year. The action last week supports that view.

Most are blaming the market’s plunge on fears of a “bond bear market” as the spurt in wage inflation Friday caused another surge in yields, giving bond holders a new reason not to like bonds. Many investors still think rising rates must be bad for stocks and ignore the evidence to the contrary.

This chart of the yield on 10 Year T-Notes (in pink) and the S&P 500 (in blue) goes back to 1998. I think it is helpful to view the current action in terms of the past activity. The yield on the 10 Year T-Note has risen from a low of 1.458% in June 2016 to the current yield of 2.854%.

In September 1998 the yield had a low of 4.41% and by January 2000 it had risen to 6.67% (line 1). During that same period, the S&P 500 rose from 957 to 1517, a gain of 59.5%. The 2.26 percentage point increase in yields took 16 months from bottom to top then, and it has now been 20 months since yields bottomed in 2016.

In 2004, the Fed also started raising rates (line 2), and from a low of 3.35%, they peaked at 5.138% in May 2006. Of course, the stock market continued to move higher until it topped in October 2007. From the chart, you will also notice that the long term downtrend for 10 Year T-Notes (line a) has now been broken. This is consistent with a potential reversal of the multi-year downtrend.

Many are fearing that yields will move above 3% and from a technical perspective that is likely, probably this year. If yields move above 3% there is strong yield resistance in the 3.30%-3.40% area. Since MIT offered a 100 year bond back in 2011, I have been concerned that many bond holders may not understand that a capital loss in their bonds could be much greater than their yield.

For those theorizing that bond yields are rising because of increased inflationary pressures (and not an ever-improving economy), the 5.8% drop in nickel and over 1% decline in gold futures last week must have been a surprise. With so many focused on fears of the bond bear market, the question must be asked: Where are the bond investors going to invest once they sell? It seems likely that some of the proceeds will flow into stocks.

If you contributed to the recent $100 billion inflow to stock funds or ETFs, the headlines about the largest weekly decline in two years may have you worried. The general assumption is that some of this new buying came from those who have avoided the stock market for the past few years because of the “wall of worry”.

I have been arguing against the wall of worry for many years including the January 2013 (Scaling The Wall of Worry) and in February of 2016 when I urged investors to ignore the Wall of Worry. It has been my view that the prevailing bearish opinion on the economy and the stock market over the past few years has kept investors out of stocks when both prices and the risk was low.

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