After a steep pullback in U.S. stocks in the last few days from record highs set in January, investors are debating whether the market is ready to resume a march higher or if they should be bracing for a steeper correction.
REASONS TO BE BULLISH
STRONG FUNDAMENTALS: A strong economy is key to optimism that stocks will keep rising. Bulls cite a healthy labor market and strong earnings. Labor: U.S. job growth surged in January and the unemployment rate of 4.1 percent is at a 17-year low. Earnings: Wall Street now expects S&P 500 earnings growth of 18.4 percent for the year, up from a 12 percent estimate on Jan. 1 as analysts account for an earnings boost from a corporate tax cut.
“We see a continued strong macro background,” said Sameer Samana, global equity and technical strategist at Wells Fargo Investment Institute in St. Louis.
THE PULLBACK FINALLY HAPPENED: As the market steadily climbed to record highs in January, investors were nervous that the longer the market went without retrenching the more severe a pullback could be. The S&P 500 late last month reached a streak of 396 trading days without a 5 percent correction, the longest on record, according to LPL Financial. With Monday’s drop, the S&P 500 had declined 7.8 percent from its Jan. 26 record.
“It was about time to see a little bit of a correction in stocks,” Matthew Cheslock, trader at Virtu Financial, said from the New York Stock Exchange floor earlier this week.
POLICY POTENTIAL: With a U.S. tax overhaul now signed into law, investors are more optimistic that Congress may be able to pass legislation to boost infrastructure spending. That stands to directly sway shares of construction-related stocks, but could also stimulate growth more widely.
Companies “have announced significant earnings pickups as a result of the lower tax rate,” said David Katz, chief investment officer at Matrix Asset Advisors in New York. “We definitely think that is not fully factored into the market.”
RATES STILL LOW: Even as concerns about rising bond yields and interest rates spook some investors, bulls are quick to mention that rates are rising off extremely low levels.
”Rates and inflation, even though they have ticked up, are still at very low levels relative to history, monetary policy is still easy,” said Michael Arone, chief investment strategist at State Street Global Advisors in Boston.
THE LONG-TERM VIEW: Strategists are keeping their year-end targets intact. Despite the 6.2 percent drop in the benchmark S&P 500 from its Jan. 26 high to Feb. 6, investors are still expecting mild to moderate gains by year-end.
REASONS TO BE BEARISH:
INFLATION: The biggest, most commonly held fear investors are talking about right now is that inflation will rise sharply enough to force the Federal Reserve to accelerate interest rate increases. The S&P 500 fell 2 percent on Feb. 2 after data showed the biggest annual gain in wages in more than 8-1/2 years.
“If interest rates continue to accelerate to the upside, what scares the market is if they go up fast,” said Robert Phipps, a director at Per Stirling Capital Management in Austin, Texas
LINGERING VOLATILITY: Shaken after months of a relatively subdued market, Wall Street is bracing for more severe swings ahead. While some traders view this as opportunity, the renewed volatility also could make investors more skittish about stocks.
“The market is in concussion protocol here,” said Walter Todd, chief investment officer with Greenwood Capital in Greenwood, South Carolina. “It took a very violent hit over the last several days, there are going to be some lingering effects from that.”
Investors are also keeping an eye on other potential risks: U.S.-North Korea tensions, an ongoing probe of possible ties between President Donald Trump’s election campaign and Russia and the possibility that Democrats could gain ground on Trump’s Republican party in U.S. mid-term elections in November.
MORE SHOES TO DROP: The stock slump led to a massive unwinding of a short position in products related to the VIX volatility index, as Credit Suisse and Nomura announced the shuttering of their respective exchange-traded notes that bet on lower volatility.
“Is there some systematic risk that we are not seeing as a result of some of these trades that are being unwound?” said Greenwood Capital’s Todd.
STRETCHED VALUATIONS: Even after the pullback, stocks look expensive to some investors. The S&P 500 was trading on Tues. at 16.9 times Wall Street estimates for the next 12 months compared with its 20-year average of 16.4 and the 20 year median of 15.6.
”We’re dealing with a very historically expensive market offering little attractive value. I expect investors will get a better entry point in the future,” said Michael O’Rourke, chief market strategist at JonesTrading in Greenwich, Connecticut.
CHANGE AT THE FED: Investors have generally expected a smooth transition from Janet Yellen to Jerome Powell as Fed chair, with little difference in approach to rate policy.
But a change atop the U.S. central bank still adds to the uncertainty in the market, and the pullback could test whether Powell’s leadership will provide a “put” that supports stock prices as had been the expectation for investors under past Fed chairs.
“Until we see what Powell policy is, the markets aren’t likely to give the Fed the benefit of the doubt,” said Michael Arone, chief investment strategist at State Street Global Advisors in Boston.