The spookiness factor has largely been absent from Wall Street. But that doesn’t mean investors should assume nothing can go wrong and that stocks won’t go down.
It’s been 15 months since the Standard & Poor’s 500 stock index had its last scare, a 14.2% dive at the start of 2016, according to CFRA, a Wall Street research firm. That broad market tranquility is reflected in a closely watched Wall Street “fear gauge,” which is on track to post its lowest average angst level for a 52-week period since its inception 27 years ago, according to State Street Global Advisors.
That calm is also reflected in the lack of wild price swings.The broad market has closed up or down more than 1% only four times this year. That’s well below the five-year average of 49 annual swings of more than 1%, according to S&P Dow Jones Indices.
But now’s not the time for investors to get complacent. Stocks continue to hover at or near record highs despite unsettling political turmoil in Washington, unnerving geopolitical news and a market that is no longer cheap relative to corporate earnings. Wall Street has been pushing stock prices higher amid a rebounding global economy, robust profitability for U.S. companies, and hopes that President Trump can get his stimulative economic agenda enacted by U.S. lawmakers.
Corrections, or drops of 10% or more, can strike at any time. And they occur more often than investors think. In fact, drops of this magnitude occur every 18 months, on average, according to Sam Stovall, chief investment strategist at CFRA. The good news is corrections are often short-lived and don’t morph into full-blown bear markets, or declines of 20% or more.
And while averages don’t always have the greatest predictive power (stocks, for example, enjoyed a correction-free period of nearly three-and-a-half years in the 2002-2007 bull market) the recent stretch of minimal turbulence won’t last forever.
“The market is always vulnerable to a news event, an economic event or an earnings event,” says Robert Sluymer, managing director of technical strategy at FundStrat Global Advisors, a Wall Street research firm.
Causes for concern
So what are some potential headwinds or shocks that could cause investors to aggressively sell stocks and push the market down 10%?
Leading tech stocks roll over. The market has been powered higher by big gains from large tech companies that now dominate market share in their respective businesses. If market leaders like social media giant Facebook, iPhone maker Apple, online retailer Amazon, and search giant Alphabet, the parent of Google, suddenly fall out of favor with investors, the overall market could suffer a steep decline.
The reason: These companies have a disproportionate effect on the price movements of indexes, such as the Standard & Poor’s 500 and Nasdaq composite. All four stocks suffered losses of more than 3% Friday in a big tech-driven selloff, driving the Nasdaq down nearly 2%.
“If we are to get a deeper correction it will be marked by deteriorating conditions, such as tech stocks weakening meaningfully,” says Todd Sohn, an analyst at Strategas Research Partners, a Wall Street research firm.
“The cloud” lingering over Trump agenda. “Instead of trumpeting big league deals and legislative achievements, today’s (political) headlines read like a Tom Clancy novel; ” notes Michael Arone, chief investment strategist for State Street Global Advisors’ U.S. exchange-traded funds SPDR business. The fear is that Trump’s political troubles become so bad that what the president refers to as “the cloud” hanging over his administration doesn’t clear and causes legislative gridlock.
“The major risk for the market is if the wheels fall off the administration,” says Vincent Reinhart, chief economist at Standish Mellon Asset Management. “The hardest thing to know is what is already in market prices. If investors are assuming too much about what the Trump administration can deliver, then there is lots of scope for disappointment.”
Pricey stocks turn cheaper. Value is getting harder to find, as the S&P 500, a broad U.S. stock market gauge, is trading at more than 18 times its estimated earnings for the next four quarters. The market’s current valuation, when measured over the past 25 years, which spans three bull markets and two bear markets, is now in the 89th percentile. That means valuations have only been higher 11% of the time over the past quarter century, data from State Street Global Advisors show.
The risk is if U.S. economic growth suffers another sudden downshift, it could result in lower corporate earnings and cause investors to sell stocks, a recent report from Bank of America Merrill Lynch warns. If growth slows, earnings “would likely return to the path seen in recent years – barely above zero,” BofA wrote in its report. If profit growth in 2018 and 2019 is closer to zero based on current market valuations, the bank said there is “13% downside potential for the stock market.”
Fed makes a mistake. Wall Street pros also say there’s a risk if the Federal Reserve makes a mistake, and raises interest rates too quickly or too aggressively. That could result in an economic slowdown, which would weigh on corporate earnings and stock prices.
“There’s always a risk that the psychology of the market could change and turn negative,” says Tom Siomades, head of the investing consulting group at Hartford Funds. But a mood shift to pessimism is unlikely to occur until there are clear signs of a growth slowdown.
“If we start to see weakness worldwide you could see a 10% event (market drop),” he says. “But we are not there now.”