Friday was a scary day in the markets, as pretty good economic news was met with a downturn in stock prices. The S&P 500 dropped 1.25 percent, and the Nasdaq dropped a scarier 2.6 percent.
Probably the best way to look at this is to realize that there is no problem here—volatility like this is completely normal. Let’s review the facts:
The correct action right now might be to sit tight. At the same time, however, investors should be paying more attention. The fact that good news was treated as bad news on Friday may suggest that investor psychology has started to shift.
Looking at the papers, today, I see further signs of such a change. There are articles on how earnings growth is slowing and may not beat even lowered expectations. There’s an article on how company share buybacks are hitting a wall, and how they typically peak at the same time a bull market does. These are factors I’ve been mentioning here on the blog for some time, and watching them pop up on the same day in the mainstream media suggests investors at large are starting to pay attention.
The declines so far have been led by momentum stocks—those that have been driven to very high levels by investor enthusiasm, like biotech or Tesla. The more stocks are priced on enthusiasm and expectations, the more vulnerable they are to corrections. So far, so normal. As we saw from the greater decline in the Nasdaq on Friday, as compared with the S&P 500, this is a significant factor.
The problem is that the expectations built into the broader market, although certainly less extreme than those of, say, Tesla, are also above historical levels. So a shift in expectations could be catching. Spring is great, but there are such things as nasty spring colds.
Another reason for caution is how the market has been acting over the past couple of months. The prompt recovery from the Russian annexation of Crimea was encouraging, but the repeated pattern of increases followed by declines, with an overall failure to move much higher, suggests we may have stalled. The question now becomes, What could break the pattern and cause a move higher?
Hard to say at this point. Unless the recovering economy drives earnings significantly above expectations, which appears unlikely for the first quarter given the weather effects, there are few obvious positive surprises out there. In the mix of cautious optimism, I am leaning more toward caution at the moment.