The stock market looks vulnerable right now, and several factors could cause it to take a meaningful tumble.
The first is all about the number 4607. That’s the
S&P 500’s
intraday high for the year, hit in late July. At just under 4600, the index is currently up about 19% for the year, but every time it nears the intraday high, sellers come in to knock it lower. If sellers keep coming in near this level, it could eventually cause a wave of additional selling.
The market has soared to this level on optimism that the economy and corporate profits can keep growing, as the U.S. has thus far avoided a predicted recession. It’s also possible that the Federal Reserve is finished lifting interest rates, moves that were meant to cool the economy and inflation, weighing on stocks.
Money managers loaded up on stocks during the run-up, anther dynamic that could cause waves of selling. Asset managers currently hold roughly a net $800 billion in S&P 500 futures contracts, according to RBC. That’s up from last year’s low of about $200 billion, and all the buying since then has sent stocks higher. The holdings are now a just a tick under the highs since at least 2006 of just over $1 trillion. These managers may now be incentivized to monetize, selling stock and raising cash, especially if risk to the market—and their paper profits—materializes.
“Investor sentiment is on the cusp of looking overly enthusiastic again…restraining our enthusiasm for the U.S. equity market in the near term,” wrote Lori Calvasina, chief U.S. equity strategist at RBC.
That enthusiasm for stocks has become too extreme isn’t a surprise, given that the market has become less volatile. When volatility is this low, history says the market should drop harshly.
Here’s how that works: The
Cboe Volatility Index,
or VIX, has dropped to 13 from a multi-month peak of about 22 in late October. A high VIX indicates that investor uncertainty about future earnings and how to value stocks is cresting. A low VIX means the market is becoming more confident, and often coincides with an increasingly expensive stock market. Any measure of risk to the economy and profits could cause the market to drop. When the VIX enters a year under 14, as it could in the new year, the average return for the S&P 500 by the six months ended in June is down 6.9%, according to Wells Fargo.
What could drive such a drop? Not getting the one thing the market currently expects: rate cuts. The fed-funds futures market is currently reflecting a 47% chance of a rate cut in March as the rate of inflation has aggressively declined from its peak last year. But inflation is still above the Fed’s 2% target, and the Fed may not be able to cut so soon. If it does, rates across the board might drop, fueling more economic demand, and keeping inflation above the target, a potential outcome like that only provides more reason for another rate hike or two.
“The Fed faces an asymmetric payoff, with a near-term incentive to proceed slowly,” wrote Chris Harvey, equity strategist at Wells Fargo. “A premature move [cut] potentially raises inflation and creditability issues.”
That’s why the near-term probability of a rate cut could decrease, which would pressure stocks. The Fed might already have some reason to stay away from cuts. The U.S. is still adding jobs—more than expected in November—and the central bank likely holds on to some level of concern about inflation.
A drop could come from a few different factors. Don’t be surprised to see one.
Write to Jacob Sonenshine at [email protected]
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