Political Rumblings Awaken Sleep-Walking Stock Market

Stocks are reacting to increased uncertainty in the U.S. with political developments dominating the headlines. While this may be the catalyst for stock market weakness, it likely does not represent an underlying cause for sustained selling.

Political headlines tend to be more noise than news and we are hesitant to frame investment decisions around breathless reporting out of Washington, D.C.  Nevertheless, stocks have seen a broad-based sell-off into today, with the S&P 500 Index (INDEXSP:.INX) down over 1.5% and the small-cap Russell 2000 (INDEXRUSSELL:RUT) off by more than 2%.

The recent lack of downside volatility (INDEXCBOE:VIX) may be providing today’s move with an exaggerated feel. This would be only the second 1% down-day of 2017 versus 17 at this point last year, and it has been over 200 trading days since the last 5% correction in the S&P 500, the longest stretch since 1996.

The lack of volatility has led to widespread complacency among U.S. investors. Elevated optimism and deteriorating broad- market trends are more likely underlying culprits for today’s sell-off. Complacency and optimism are reflected in low-cash reserves among mutual funds and a nearly fully-invested position among active investment managers. The latest report from the National Association of Active Investment Managers (NAAIM) shows average equity exposure above 90%, which has historically limited near-term upside for stocks.

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Also unhelpful (for U.S. stocks) is that at the margin, liquidity is moving overseas. Last week, more than $6 billion poured into European equity funds, the most since 2000. While the popular averages have made new all-time highs recently, the new number of stocks on the new high lists has been relatively meager and the percentage of industry groups and sectors in up-trends has deteriorated. We have also not seen confirmation of strength coming from typical market leaders like the Dow Transports or the Broker/Dealers.

Add to this a continuing spate of economic data releases that have fallen short of expectations and a stock market pullback right here would not be surprising or even unhealthy. While political events tend not be good timing indicators on their own, in this case it may help speed the process of providing the market with a significant low if we are able to see widespread oversold conditions accompanied by a more pessimistic and skeptical stance from investors.

Bottom Line: Stocks have been overdue for a volatility wake-up call. With the S&P 500 breaking below 2380 (which had marked the bottom of the narrow month-long trading range) the next level of support comes near 2330.

Thanks for reading.