What About Yesterday’s Stock Market Pullback?

Yesterday, we finally saw a market decline of more than 1 percent, after a very long time without one. Is this the end of the rally?

Short answer: probably not.

A perfectly normal move, all in all

Let's take a step back and consider the context:

• Yesterday’s pullback takes us all the way back to the level of . . . the middle of February, about five weeks ago, which was an all-time high at the time.
• The market is just over 2 percent off a more recent all-time high, and stock prices remain at elevated levels.
• A move like yesterday’s is normal market behavior, even in a bull market.

Overall, the market remains healthy but seems to be adjusting to a recent dearth of good news.

Think about it: Since the election, stocks have been driven higher on improving sentiment, improving facts on the ground, and actual improvements in corporate earnings. There’s been a long string of good news and mostly positive surprises. The rally so far has been largely based on fundamentals, and the Fed recently ratified the recovery with not only a rate hike but plans for a series of them.

Economically, though risks remain, the market clearly sees bluer skies ahead.

What could drive prices up now?

The problem is that all of that good news is reflected in the price, and the market is reverting to the “what have you done for me lately?” mindset. The question is not what got us here, but what will push us higher.

For now, there’s no clear answer. I suspect it will turn out to be a combination of improving hard data, which has lagged the improvement in sentiment, and continued corporate earnings growth. More good news from Europe and Asia would also be helpful. But whatever it is, it’s not here yet.

This is why the market has been bouncing around recently. Although the fundamentals remain sound, that’s already baked into the price, and, absent any meaningful news, events keep driving the market up or down without a significant trend. The technical term for this is “noise,” and what we’re seeing is the market’s reaction to it.

This could get worse before it gets better

I suspect that one of the factors behind yesterday’s sell-off was political events in Washington, DC. Much of the improvement in sentiment has come from expectations for meaningful changes in governance, and recent events are starting to call that into question, perhaps prompting the pullback.

If we see continued political turbulence, we might see a more severe market decline. In many ways, in fact, we’re due for a bigger one. Arguably, it would be a healthy development and set the stage for future growth.

Even if we do see a bigger drop, the fundamentals remain sound, which should limit both the magnitude and the duration of any pullback. Major pullbacks typically require several factors coming together, the most important of which is a recession, and we simply don’t have recessionary conditions right now. With the economy growing and the Fed continuing to stimulate, conditions are more like early 2016 than anything else.

If you remember, we did have a significant pullback in 2016. Despite the fears at the time, the market just rebounded and kept moving higher. Conditions now are similar to conditions then, and I suspect that this pullback—though it could get worse—will ultimately reverse itself.

Volatility can be worrying, especially after a long calm stretch. Just remember that both the market and the economy remain solid, and conditions are more favorable than they’ve been in some time. We have seen this movie before. Keep calm and carry on.