Thoughts on the Market Selloff

Additional content provided by Jeffrey Roach, Kristian Kerr, Adam Turnquist, Colby Hesson, and Brian Booe.

LPL Research discusses some of the causes of the latest stock market selloff, including causes, perspective on the economic backdrop, bond market perspective, and technical analysis insights.

Causes of the Market Selloff

• The current pullback markets are experiencing comes as multiple market concerns have coincided over the last few days. The primary driver stems from concerns the Federal Reserve’s (Fed) higher-for-longer policy will drive the U.S. economy into recession (a so-called hard landing) following the weak payroll employment report on Friday, August 2. Soft Institute for Supply Management (ISM) manufacturing data added to the selloff in global risk assets.
• Investor sentiment had become a bit frothy, causing us to suggest stocks had gotten a bit ahead of themselves in LPL’s Midyear Outlook 2024: Still Waiting for the Turn, published in mid-July. The historically seasonally weak month of August was a logical time for a selloff to occur to reset investor sentiment to more normal levels. Increased scrutiny around the payoffs for artificial intelligence (AI) investments acted as another catalyst for the selling. The magnitude of the selloff was then exacerbated by elevated valuations and systematic/quantitative institutional investors unwinding their bullish positions.
• Weakness was further exacerbated by the continued unwinding of yen carry trades following last weeks Bank of Japan rate hike and a hawkish tone from the Bank of Japan Chief Kazuo Ueda. A carry trade is simply when investors borrow in a currency with low interest rates that is cheap to borrow, and invest in a currency with relatively higher interest rates. Fragilities in global financial markets can become evident during episodes when these trades unwind rapidly. It’s like a margin call forcing borrowed yen to be repaid, which drives yen buying — and in this case, a yen spike. In fact, the historic policy change at the Bank of Japan was most likely a bigger catalyst for market volatility than the latest payroll report.

Watching for Risks of Contagion Amid Economic Slowdown

• Clearly, last week’s snapshot of the labor market is consistent with a slowdown, and we have warning signs suggesting more weakness. One such sign is the rising number of those working part-time for economic reasons, which rose to the highest since June 2021.
• Investors should also factor in the risk of contagion from recent international volatility, which is why the Fed is highly attentive to systemic risks, both domestically and internationally. The Fed monitors elevated valuation pressures, excessive borrowing, leverage in the financial sector, and funding risks for market vulnerabilities. (Source: Financial Stability Report, April 2024 (federalreserve.gov)).
• A quick reversal in currency markets could exacerbate risks in some of these areas and could be a reason the Fed decides to cut rates before the regularly scheduled meeting on September 18. A well-functioning dollar funding market is fundamental to maintaining a healthy financial system.
• Investors should pay attention in the near term to the Fed’s use of swap lines with other major central banks. A boost in activity could signal heightened uncertainty among central bankers. International financial and currency stability is important to the Fed. When risks to that stability rise, expect the Fed to act.

Bonds Acting Like Bonds

• During this selloff, bonds are behaving as expected. Recent movements in the rate market have pushed U.S. Treasury yields lower, with the 2-year and 10-year yields closer to parity with both trading below 3.7%. The market has fully priced in the odds of two 0.50% rate cuts over the next two Fed meetings and a subsequent 0.25% rate cut in December.
• Long term, by December 2025, the market is anticipating over 2.5% in total rate cuts, which aligns with expectations for recessionary adjustments.
• Despite the potential for a slight overreach in rate declines, high-quality bonds have effectively served their traditional role as portfolio diversifiers during market volatility. We would suggest continued emphasis on high-quality bonds in investor portfolios, as they offer the optionality of further portfolio protection in these uncertain times — something cash does not offer.

Technical Analysis Offers Some Key Potential Support Levels

• Now that the S&P 500 Index has breached both its 20-day and 50-day moving averages (dma), key support levels to watch are 5,254 (March highs), 5,227 (a retracement level), and 5,011 (200-dma). Below the 200-dma, the next support level is at April’s lows at 4,954.
• Currently, momentum indicators are bearish but not deeply oversold, suggesting there may still be some additional downside potential. This morning, the Relative Strength Index (RSI) touched oversold levels but has experienced a bounce midday.
• Despite current volatility, the broader market's long-term uptrend remains intact, and most breadth metrics show minimal damage. Over two-thirds of S&P 500 stocks are still above their 200-dma. The market was also quite overbought as August began, particularly in the tech sector, where the correction has been more pronounced.
• The extreme levels of the VIX measure of implied volatility reached this morning — at one point over 60 — have historically been associated with market capitulation. But remember bottoming is a process and usually takes some time. We’re following the charts closely.
• Remember, corrections of 10% or more are a normal and healthy part of any bull market. On average, stocks correct 10% or more once per year — even in positive years. But that doesn’t mean the bull market is over.

Uptrend Still Intact as Stocks Near Oversold Levels

Source: LPL Research, Bloomberg 08/05/24
Disclosures: Indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

Bottom Line

Equities are nearing an attractive entry point, with the S&P 500 down about 8% from its July high (and the Nasdaq down 12%) as of 12:00 p.m. ET Monday. LPL’s Strategic and Tactical Asset Allocation Committee (STAAC) maintains its tactical neutral stance on equities, while actively monitoring signs the bottoming process is playing out. We don’t think it’s quite time to buy this dip yet. We suggest staying invested, be patient, and most importantly, don’t panic.

In terms of potential catalysts for a stock market turnaround, consider the following:

• A signal from the Fed that they will be more aggressive with rate cuts.
• Evidence that the economy is holding up okay rather than falling off a cliff. Today’s ISM services data was a good start.
• Some additional unwinding of trades by institutions that were caught off guard by these big moves. These include carry trades involving the yen currency and overly bullish and leveraged quantitative traders.
• A refocus on corporate fundamentals, including the Magnificent Seven’s expected earnings growth near 30% and resilient overall estimates (even as some companies warn about consumer spending pressures).
• Corporate buybacks could pick up now that most companies have reported results for the second quarter.
• A successful test of the 200-dma on the S&P 500, currently at around 5,010 but rising, could encourage big market players to step in.