The stock market’s wild gyrations this past week have been an emotional roller coaster for investors, and the ride has not come to a full stop.
It feels bad right now, and strategists say it could get worse as the market tries to find a floor. Overall, there have not been many periods like this, in which the Dow Jones Industrial Average swings a gut-wrenching 1,000 points in both directions, and stocks move up and down several percentage points in one day.
But strategists say the big moves are not uncommon when the indexes are down substantially. In this case, investors are adjusting to a major shift by the Federal Reserve. The central bank is moving away from its easy policy of zero interest rates. In turn, this has made investors reassess valuations across the entire stock market.
“It’s a tug of war and volatility is like blood pressure. It’s elevated when you’re scared, anxious, nervous and uncertain,” said Sam Stovall, chief investment strategist at CFRA. The first stocks to get hit were the high-flying names that benefit from low interest rates, and then the sell-off spread to other growth and tech stocks before encompassing the entire market this month.
According to Bespoke, the S&P 500 has had an intraday range of at least 2.25% every day in the past week. The major averages ended Friday higher, wiping out the week’s losses, after pulling off another late day reversal.
For the week, the Dow was up 1.3%, the first positive week in four. The S&P 500 edged up 0.8% to 4,431 to end the week, and the Nasdaq Composite was flat.
The S&P was 8% off its all-time high as of Friday’s close, and is down 7% for the month of January. The Nasdaq is 15% off its high, and is down 12% for the month.
Why the market has been rock
“That’s what these policy pivots are all about. In the first part to the business cycle, the Fed is easy and growth is recovering rapidly. You have earnings going up. You have easy monetary policy and you have incredible wind in the sails,” said Barry Knapp, director of research at Ironsides Macroeconomics. “That’s what we had last year. But the Fed wasn’t supposed to let it go that long and they haven’t in other business cycles, and that’s why it created a violent reaction.”
This past week, the central bank made markets even more nervous when Fed Chair Jerome Powell briefed the media. Powell acknowledged the Fed could move even faster than the four rate hikes markets had expected for this year. The futures market immediately moved to price in five hikes for 2022.
Michael Arone, chief investment strategist at State Street Global Advisors, said investors are also realizing that earnings are not as robust as they had been.
So far, 77% of companies are beating estimates now for the fourth quarter, and they are reporting earnings 4% above expectations, according to Refinitiv. That is well below the 16% average of the last four quarters but in line with the long-term average.
“This all kind of results in additional market volatility until investors digest this transition period,” said Arone. “On the other side of this, the economy should continue to expand, earnings are pretty good. That’s enough to sustain markets, but I think they’re adjusting to the shift in monetary policy, fiscal policy and earnings.”
The wild swings make investors even more nervous because of the relative calm last year.
Stovall said the normal average length of time between declines of 5% or more in the S&P 500 is 104 days, but in 2021, the S&P 500 went for 293 calendar days before falling more than 5% in September 2021. Prior to that, the market had pulled back more than 5% between September to November 2020.
What’s behind the moves
Knapp said when the market was in a lull, big investors were using options and futures to hedge for a low volatility market. The shift to a market that makes sudden moves is forcing them to change strategies, and the process is part of the reason for the huge bumps in the stock market.
“When the Street and market makers are no longer long short-term volatility, when they can’t afford to hold it because it’s way too expensive, market makers are no longer there to cushion the blow, and that’s when it gets wild,” he said.
Knapp said the investors will ultimately hedge for a wider range of volatility and the market will calm down, but the intraday moves will likely stay more elevated than they were.
The big swings also correlate to trades around key levels in the market, like the ones linked to moving averages. The S&P 500 fell through its 200-day moving average last Friday, setting it up for Monday’s big drop to 4,222 points. The S&P bounced off that level, but strategists still look at it as a possible area for the market to test before a bottom is set.
The 200-day moving average is viewed as an important momentum indicator. A drop below it for a sustained period suggests more downside, and a break above it could indicate a bigger up move is ahead.
“History is very clear on this point, when you breach the 200-day moving average with conviction, like we did … regardless of what causes that breach, typically what happens is you get a big swoop down 10%, 12%, 15%, which is what we got,” said Darrell Cronk, chief investment officer for wealth and investment management at Wells Fargo.
Cronk said in an interview on CNBC that the market is then set for a counter rally back by possibly 4% to 7%. “Often, you get the real low set in from there, meaning another 10%, 15%,” said Cronk. “That happened in 2020. It happened in 2018. It happened in 2011. So, I think investors just have to be a little cautious here in the near term because the lows might not be in yet on this type of correction.”
Cronk said he still expects stocks to be higher this year, but investors should be cautious now.
Rising rates
Stovall said a key metric to watch is the course of the 10-year Treasury yield, an important benchmark that influences mortgages and other lending rates. On Friday afternoon, it was at 1.78%, off its highs for the week. The yield also influences investors’ views of the valuations of stocks.
Stovall said the move higher in the 10-year suggests that price-to-earnings ratio for the S&P 500 has room to move lower.
The price-earnings ratio is currently at 21 times on a 12-month trailing basis, down from 23.1% at the end of the year. That means investors are paying 21 times last year’s earnings. When the price of stocks moves lower, so does the price-earnings ratio.
Stovall studied what happens to that ratio when the 10-year yields between 1.75% and 2.25%. He found the high P-E ratio was at 19.7% during a period in 2019, but that it averaged closer to 16%.
“In order for us to go from 23.1% down to the upper range of these observations implies an almost 15% decline,” he said.