Changing Tone And Reassessing: Rough Week Ends With More Softness As Long Rally Slows

Key Takeaways:

  • Market finishes tough week on a softer note amid valuation, volatility concerns
  • Short squeezes a sign of disruption, tone change occurring in markets
  • Focus on weak data, mixed earnings, slow vaccinations add to selling pressure

You could argue that the market spooked itself this week.

Now it wasn’t as if there weren’t external reasons for the downturn. Between worries about slow vaccine rollout, weak European economic data, the appearance of the South African variant of the virus here, and a few disappointing earnings reports, it’s easy to find a fundamental story to blame.

Still, it feels like the selloff, which accelerated Friday as the S&P 500 Index (SPX) fell nearly 2%, was more of a reaction to internal market developments. Anyone who’s paid attention knows about all the focus on short squeezes that brought fame (and some fortune) to stocks like GameStop GME (GME) and AMC AMC Entertainment (AMC). There’ve been disruptions all over the world, and now the stock market is feeling some disruption and a change of tone. The short squeezes certainly had a lot to do with it. The way people interact with the market is a little different than in the past.

There’s also a sense that things in general had come too far, too fast, sending values too high and leading to calls for a little consolidation. Basically, the four main stock indices had rolled along full steam ahead with hardly a break since early November, and that made some people nervous, especially about valuations. The short squeezes seemed to reinforce some investors’ beliefs that it was time for a little profit taking.

It’s a storm of a lot of things coming together that’s leading to a disruption in the market overall. These kinds of disruptions occur every 10 or 12 years and the market has always survived them. People are reassessing their portfolios. Not just individuals, but funds, too. There’s a reassessment of value everywhere.

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Some of the major stocks leading the downward charge Friday included all the “FAANGs” along with Microsoft MSFT (MSFT). Apple AAPL (AAPL)—which often has an outsized impact on the overall market due to its huge valuation—is down 8.5% since reaching an all-time high early this week. That’s despite a stellar earnings report. That’s the kind of thing that makes you wonder if we’re seeing some good old-fashioned profit taking.

From a sector standpoint, it looks like a few of the ones that had been doing best on the recent rally have fallen the hardest, including Energy, Info Tech, and Financials. The so-called “defensive” sectors, including Utilities and Health Care SBRA , did best on Friday.

Bumpy Ride Not Out of the Ordinary

It never feels good to lose money in the market, but it should feel familiar. Major indices generally experience several 5% drops each year and usually at least one 10% decline. The SPX hadn’t had any sort of serious backtracking since September when it fell around 9.6% from its highs. Then it went on a tear, chalking up gains of nearly 18% from the end of October up to its all-time highs earlier this month.

Gains were even heavier for the small-cap Russell 2000 Index (RUT), which entered this week trading at about 1.37 times its 200-day moving average, the highest it’s been relative to the 200-day since at least 2000. Hopes for further fiscal stimulus, the Fed’s dovish monetary policy (which it again promised this week to keep that way for the long term), and vaccine progress all helped electrify Wall Street between November and January.

Now it feels like maybe things got a little ahead of themselves, considering all the challenges we still face. Europe is running low on vaccines. The U.S. rollout has been slower than expected. The Johnson & Johnson JNJ (JNJ) vaccine data today looked OK, but not amazing, and none of the vaccines seem to be as effective against this South African variant that has medical experts sounding nervous. Gross domestic product (GDP) growth in Q4 wasn’t quite as good as some people had hoped and moderated from the breakneck pace of Q3.

Combine all that with earnings from Facebook (FB) and Tesla TSLA (TSLA) that didn’t blow anyone out of the water, cruise lines once again pushing back their schedules, a bond market that showed new life, rising volatility, and an SPX valuation at historic highs, and it would have been kind of weird not to have some weakness in stocks.

Key Levels to Watch Include 30,000 in $DJI and 3700 in SPX

Despite this disappointing end to the week, try to keep things in perspective. The SPX is still up 13.5% in the last three months, and remains around 3.5% below this month’s all-time highs. If a market correction is defined as a 10% decline from the high, we’re not even halfway there yet. That might feel reassuring in one sense, but it should also mean caution. There could be more weakness ahead if this downturn is going to become a correction, which can’t be ruled out.

The argument against that is there just hasn’t been a lot of interest among investors to really push the market down over the last few months. Every time the SPX dropped to its 20-day moving average since Nov. 1, it met new buyers in what became called a “buy the dip” trade.

This week the SPX actually did fall below the 20-day and then tested the 50-day moving average, which was 3715 heading into Friday (see chart below). The question heading into next week is whether any technical support in that area holds, or if selling picks up. Longer-term technical support is in a range between 3633 and 3695, according to research firm CFRA. This is where the “buy the dip” crowd meets a test: Will they still want to buy the dip after the main crunch of earnings season ends and the world continues to stumble trying to fight the pandemic?

The two big numbers to watch could be 30,000 in the Dow Jones Industrial Average ($DJI) and 3700 in the SPX. The two indices flirted with those levels late Friday, and the $DJI ultimately closed just below 30,000. If it hops back above there Monday and manages to hold on, that would probably be seen as a technical victory that could promise a little recovery ahead.

It’s kind of interesting that all this happened at a time when you could point to some actual positive developments in the background. Microsoft (MSFT) and Apple (AAPL) both reported earnings that are about as solid as it gets and next week brings Alphabet (GOOGL) and Amazon AMZN (AMZN). Other big names penciled into the earnings lineup next week include PayPal PYPL (PYPL), Alibaba BABA (BABA), UPS (UPS), and Peloton (PTON). We’ll talk more about those reports and what to look for in them on Monday morning.

As these companies report, stimulus traction appears to be growing on Capitol Hill. Media coverage this week suggested Democrats might try to speed the $1.9 trillion legislation through Congress through reconciliation, which wouldn’t necessarily require Republican votes. Whatever you might think of the legislation itself, stimulus generally appears to have helped the stock market over the last few months. Next week we’ll see if it elbows its way back into the headlines in a big way, which has potential to be a helpful force for the market.

Volatility Explosion Could Keep Investors Cautious

What’s not helpful is the way volatility just exploded this week. On one day, the Cboe Volatility Index (VIX) skyrocketed to 37 from below 22. This isn’t something you often see, and overall the VIX had its biggest upside week since June.

Historically, VIX—sometimes called the market’s “fear index”—trades in ranges over periods of time. It spent a lot of time last fall between 25 and 30, and then early this year between 20 and 25. Now it’s back above 30, and that could indicate more concern about possible choppiness and deeper losses straight ahead. One interesting thing now vs. a week ago, however, is that VIX futures have gone from contango (where outer months are higher than the current level) to backwardation, where the current level outweighs future prices.

It was also positive to see the major indices bounce off of their lows late in Friday’s session, which could have positive ramifications as the new week starts. The SPX at one point on Friday dipped just below 3700, but didn’t seem to find much selling interest down there. One hallmark of last year’s steep selloff was failure to find buyers late on Fridays who were comfortable holding long positions into the weekend. This sometimes caused late-week selloffs to gain steam. That didn’t appear to be the case Friday, which isn’t a bad thing if you’re hoping for better times ahead.

Earnings, stimulus, and vaccination progress all remain key areas to watch as the new week begins. Also, consider closely checking futures market action Sunday night for possible clues about how Monday could open.

Despite Headlines, Vaccine Progress Appears Confirmed this Week

One more thing: JNJ’s vaccine data today took some of the blame for the market weakness, but most analysts didn’t think the data was actually all that disappointing. As they said, it appears to be more effective than the flu vaccine we all get each fall, and it also seemed effective in preventing severe Covid-19 cases.

The data showed it wasn’t as effective as the Pfizer PFE (PFE)/BioNTech (BNTX) and Moderna (MRNA) vaccines already on the market, but few experts had expected that. JNJ was upbeat about the data and analysts said it’s expected to seek quick regulatory approval. Logistically, the JNJ vaccine has a bunch of advantages because it’s a single-injection product that can be stored at much higher temperatures than products made by the other companies.

There was also positive vaccine data from Novavax NVAX (NVAX) this week, and its shares jumped more than 60% on Friday. The company is considering filing for U.S. approval, news reports said. Which means in a best-case scenario, the U.S. might soon have four vaccines on the market actively fighting against this horrible pandemic. The U.S. government agreed last year to buy 100 million doses of JNJ’s vaccine.

So maybe those are some things to keep in mind if you’re feeling depressed about how this week turned out.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

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