As I look at my terminal I see almost all red. At the time of writing the S&P 500 just hit 1801 and the Dow Jones Industrial Average has dipped below 16,000. Meanwhile, volatility is up almost 30% in the past week alone.
The question is whether this is a correction or a sell-off. There is real panic, but bonds aren’t up as much as this decline would imply. The 10 year Treasury yield has fallen four basis points, with TLT almost flat for the day. This means that we are not seeing a flight to safety. This could be a simple case of fund redemptions — i.e., people taking cash out of mutual funds, ETFs, and so on — which could suggest that the market is not expecting stocks to outperform in the long term. Or it could just be a case of profit taking.
A more ugly alternative is that this is the beginning of the end of a now several-year old bull market. Yesterday, China’s flash marketing PMI showed the first contraction in six months, a sign that Chinese manufacturers are not producing more than they had been, which could be a leading indicator of a decline in aggregate demand. If this is the case, we could be at the very beginning of an economic downturn that will first begin with a decline in individual consumption, and then a decline in private sector investment, and then a GDP contraction in various markets.
The weakness may be in developing markets, which saw an unmanageable flood of cash in recent years that may have been the result of the Federal Reserve’s efforts to grow the monetary base through its Quantitative Easing programs. Now with the Fed tapering the most recent program, we could see a slowdown of cash in those markets and weaker currencies in these markets, which in turn will lower emerging market demand and just exacerbate the slowdown we’re seeing in the China PMI.
We are now seeing very complex macroeconomic factors that may be bearish, but what about earnings? So far, earnings have been okay for those S&P 500 companies that have reported, although we’re early in the quarter. Soft demand from bad weather in the United States and rising energy prices were concerns, but they did not hamper earnings growth too much, which has helped the S&P 500 remain range bound for the past few days. Most recently, Microsoft (MSFT) and Starbucks (SBUX) reported solid earnings that indicate both b2b demand (in the case of MSFT) and consumer demand (from SBUX) are on a decent trendline.
But with the China PMI and emerging market currency issues, eyes have quickly come off earnings and gone straight to macroeconomic issues and the question of the taper. For as long as this remains an issue for investors, we could see an uneasy stock market. That may not last long, however. Next week the FOMC meeting on January 28 and 29 will most likely respond to the fall in stocks we’ve seen this week, and they may address the issue.