Can this bounce in the stock market be trusted?

Published Sat, Oct 9 20219:02 AM EDTUpdated Sat, Oct 9 202110:06 AM EDT

Over the past five weeks, external threats and internal complications have triggered a fight-or-flight response among investors, sending the equivalent of stress hormones coursing through the market. Higher volatility and trading volumes, a renewed focus on seeking protection and twitchy, emotional intraday reactions are the symptoms. While the tape remains under pressure from a few sides and last week's bounce was not fully convincing, the market so far is passing this ongoing stress test, supporting the likelihood that it's more routine correction than damaging downturn. The fact that the turbulence started on cue as the seasonal script turned challenging is, in its way, modestly reassuring to the bulls, the market conforming to the usual rhythms. And for a second straight year, even. Both in 2020 and this year, the S & P peaked on Sept. 2, sank into the third week of the month, enjoyed a partial, failed bounce and then retreated lower into October, all with gyrations around the index's 100-day average and a rotation away from dominant tech stocks. Last year things stayed dicey until Oct. 30, and the magnitude of the decline then was greater, and the election plus new vaccine success were tidy upside catalysts. Still, for what it's worth, the typical seasonal cadence is about to turn less hostile, as this chart of the 2021 S & P 500 path relative to the average annual course shows. As the differing left-right scales show, the amplitude of the moves this year are far greater than the average, but the ebb and flow has been pretty similar. After Friday's market close, the Stock Trader's Almanac advisory service issued a seasonal buy signal on the major-index ETFs, based on certain technical readings meant to capture the turn from negative to positive seasonality in October. Risk appetite weakens The stress of the market pullback has taken a toll on the psyche of investors in measurable ways, which can also be viewed as helpful in bringing about an eventual market recovery. The long-running weekly Investors Intelligence poll of investment-advisory services registered a plunge in net bullishness to an 18-month low, which along with a similar collapse in retail-investor optimism and uptick in protective put-option volumes show the defensive swing in risk appetites are pretty far along. Deutsche Bank reports that overall investor positioning in stocks has fallen from an extreme high to a more middling level as of Friday. "With positioning at neutral," says Deutsche strategist Prag Thatte, "it is no longer an argument by itself for a further selloff in the absence of clear catalysts impacting the fundamental outlook." Such catalysts could be lurking, of course, in the form of a worsening energy squeeze in Europe, a flare-up in slowdown fears due to supply-chain havoc or ongoing valuation compression as corporate-profit growth levels off. What are the real threats? But macroeconomic stresses are not emerging in any clear way in the credit or equity-derivatives markets yet, though. Junk-bond spreads relative to Treasuries have been stable throughout the equity setback at undemanding levels. While the Volatility Index (VIX) has bobbed around, reaching the upper 20s in late September, it has settled back into the high teens. And more crucial, there are not yet any worrisome contortions in the VIX futures curve looking out to coming months, of the sort that usually reflect trapped institutions or dangerous vibrations hitting trading portfolios. In fact, some market watchers might want to see a burst of such panicky action before assuming this pullback has reached a proper climax. Barry Knapp of Ironsides Macroeconomics has been calling for a 10%-to-12% correction to account for waning policy support, downward earnings revisions and a Federal Reserve that might find itself rushing to counter stubborn inflation. Based on various derivatives indicators, he says "equity volatility markets have not yet reached a level that implies investor positioning is sufficiently defensive such that a sustainable rally is likely." There's no escaping the ongoing pressure applied to the market from the combination of shortage-driven energy-price gains and ubiquitous supply-chain kinks – including, as Friday's payrolls data showed – the supply of available workers to fill millions of open jobs. Historical investor muscle memory means fast gains in oil and gas prices stoke worry. It's probably premature to assume the U.S. economy is near a crucial pain threshold, though. West Texas crude on Friday reached $80 for the first time in seven years , but oil was above that price from 2010 into 2014, in a far more fragile economic recovery at a time when GDP and consumer incomes were much lower. This chart shows energy and related services spending near record lows as a percentage of total personal consumer expenditures. As for supply-chain challenges, FactSet says 15 of the 21 companies that have so far reported third-quarter earnings have cited them in their quarterly conference calls, so it's a very good bet that the coming weeks will be a cacophony of such discussions – and a good test of whether the market might already have largely discounted them. Buyable correction? On a more tactical and technical level, the broader picture is that the S & P 500 tagged the +20% year-to-date gain level coming into September with investors all-in on stocks and riding long win streaks of monthly gains (seven straight) and months without a 5% pullback (ten). Time and mean-reversion caught up to the indexes, both streaks ended, a reset has been underway to account for a mixed growth picture and policy flux in a tougher seasonal period. The indexes – especially Nasdaq 100 – got quite oversold into last Monday's low, and stocks have bounced nicely but the rebound stopped at "logical" levels, failing right at the S & P 500's 50-day average Thursday, just to keep everyone guessing. To reiterate: It remains unlikely that the S & P 500 would have peaked for the year on Sept. 2, given the history of similar years, where we are in the profit cycle and the pattern of how the first 5% pullback in a long time tends to play out — the first 5% drop has almost never been "the big one." This would mean this ultimately has been, or will become, a buyable correction, given the calm waters in the credit markets, failure of defensive sectors to take the lead and flush corporate coffers. This is probably how this stressful period ends, even if it turns out it's not over yet.

A specialist trader works inside a booth on the floor of the New York Stock Exchange (NYSE) in New York City, October 6, 2021.

Brendan McDermid | Reuters

Over the past five weeks, external threats and internal complications have triggered a fight-or-flight response among investors, sending the equivalent of stress hormones coursing through the market.