Whiff of a bear market for US stocks is in the air
In mid-February, the benchmark US S&P 500 equity index closed above 2100 for the first time. A remarkable six-year-long rally in US stocks continued throughout the spring and into the summer, with the index hitting another record high as recently as mid-July.
Then, all of a sudden, sentiment began to deteriorate - abruptly and sharply.
Since July 20, the S&P 500 has dropped 11.6 per cent - the first time in roughly four years that the index has experienced a drop of 10 per cent or more from a recent high, known as a “correction” in Wall Street parlance.
While the resilience of the S&P 500 should not be underestimated - after plunging 11 per cent between August 17 and 25, the index rose 6.5 per cent in the ensuing three days and is still trading slightly above its August 25 low despite falling 2.6 per cent on Monday amid another sharp sell-off in global equity markets - this looks and feels like the end of a bull run.
The whiff of a bear market for US equities is in the air.
A number of factors have conspired to undermine sentiment more significantly than was the case during previous bouts of risk aversion - so much so that a new trading regime appears to be developing in which investors are no longer willing to “buy the dip” but instead are more inclined to “sell the rally”, according to a note from Old Blackheath Companies, an investment advisory firm.
While turning points are always difficult to pinpoint and there were already growing concerns about lofty valuations and lacklustre revenue growth before the correction, the China-driven rout in commodities markets, worries about global growth and mounting uncertainty about the conduct of US monetary policy - three concerns which have become much more acute over the past fortnight - are clearly having a corrosive impact on sentiment.
The Vix Index, Wall Street’s “fear gauge” which measures the degree of anxiety among equity investors based on S&P 500 options, rose nearly 50 per cent in the third quarter of this year and has stood above 20 - a level widely viewed as signalling heightened stress on Wall Street - since August 21.
The unexpected decision by the US Federal Reserve on September 17 to justify leaving its benchmark interest rate on hold mainly because of concerns about China’s economy and policy regime has contributed to increased nervousness in stock markets.
While a badly communicated increase in US rates - or one which was perceived as insufficiently dovish given expectations of a gradual tightening in policy - could have had an even more negative impact on sentiment, the Fed has amplified concerns about EMs and raised further doubts about the credibility and conduct of US monetary policy.
Although the Fed’s quantitative easing (QE) programme has been a key pillar of support for US equity markets, traders and investors are now more frustrated by the persistent uncertainty regarding the timing of a rate hike - particularly in view of the relative strength of the US economy.
Yet while the US recovery has been significantly brisker and more robust than Europe’s, the outlook for corporate earnings - the reporting season kicks off in less than a fortnight - has deteriorated significantly, mainly because of the plunge in commodity prices. According to Thomson Reuters, analysts expect US earnings to decline more than 4 per cent in the third quarter, compared with expectations of a slight rise at the start of the quarter.
It is also troubling that the sector that drove the rally - pharmaceuticals and biotech stocks - is the one that is now leading the sell-off because of concerns about government intervention in the pricing of medicines, with Hillary Clinton, the frontrunner to be the Democratic nominee in next year’s US presidential election, particularly critical of price hikes by pharma companies.
Renewed concerns about political gridlock in the US, initially centred round the risk of a government shutdown but now more focused on the challenge of agreeing a long-term budget deal and raising the debt ceiling, are also weighing on sentiment.
Still, a bear market - usually defined as a share price drop of 20 per cent or more from a recent high - for US stocks is not preordained. On Wednesday, stock markets were rising again.
For the time being, volatility, as opposed to capitulation, is the watchword.
Yet with a whopping US$11 trillion wiped off the value of global equities in the third quarter, and the S&P 500 suffering its worst quarter since 2011, the omens are not good.
Nicholas Spiro is managing director of Spiro Sovereign Strategy