A Touch of Grey

Sep 13, 2021

By Pete Biebel, Senior Vice President

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The stock market’s skies darkened a bit last week. The sunny economic conditions in recent months, along with a pleasing tailwind of strong corporate earnings, have created an environment in which the major averages were able to slough off a variety of potential threats and rack up an impressive string of record highs. But the skies were not so bright last week, and it seemed that more clouds rolled in as the week went on. Most stock indices lost ground in each of the week’s four sessions.

Thankfully, the losses were relatively small. The Dow Jones Industrial Average (DJIA) was the worst of the major averages with a cumulative loss for the week of 2.15%. Both the S&P 500 Index (SPX) and the NASDAQ Composite Index (COMP) lost a little more than 1.6%. All three indices ended at their lows of the week. COMP fell below its low of the prior week. SPX ended below its low of the prior two weeks. INDU dropped to its lowest level since July 20. It’s important to understand that last week’s losses didn’t violate any important technical levels. With the averages having recently reached new highs, they had a comfortable cushion down to any price levels that might be critical. More on that later.

A few weeks ago, I suggested there were two specific areas to watch as potential early warning signs: Mega-cap tech stocks and small-cap stocks. Through spring and summer, the big tech stocks were a ray of light; they were able to pull the averages to new highs even as fewer and fewer stocks were participating in the rallies. If those big names began to fade, it might foretell dark days for the overall market. Meanwhile, small-cap stocks had been struggling and seemed poised on the verge of a breakdown. If they broke down, that would further weaken the underpinnings of the overall market. Then, in the two weeks leading into the Labor Day holiday, the NYSE FANG+ Index of mega-cap tech stocks gained nearly 10%; the Russel 2000 Index of small-cap stocks gained nearly 6% over that stretch, while SPX was up just a touch over 2%. Critically, where those groups were bright spots in recent weeks, both had their lights go out last week. RUT lost about 3% for the week while the NYSE FANG+ Index fell about 3% over just the last three sessions.

The market’s rally is also going a bit gray age-wise. The financial media keeps reminding us that it’s been nearly a year since the market has had a pullback of 5% or more. And the aging rally had been showing symptoms of its advancing maturity earlier in the summer. Measures of market breadth like advancing versus declining issues and the percentage of stocks above a significant moving average have been deteriorating even as the indices marched higher. “Every silver lining’s got a touch of grey.”

A third angle on this week’s title is that it’s also the title of a once popular song by The Grateful Dead. The song featured relatively upbeat underlying pop music supporting relatively dark lyrics. More to the point, the band’s concerts infamously always included songs that evolved into extended jam sessions. Those numbers would go on and on with the assembled audience of Dead Heads dancing and whirling to the music for very prolonged periods of time. That presents a fitting image for our stock market: the continuing flood of fiscal and monetary stimulus has kept the market participants giddily dancing and whirling as the music plays on.

It doesn’t take a lot of gray matter to theorize that the market could be dancing itself into a gray area. With last week’s weakness, more analysts at major financial institutions are pointing to factors like stretched valuations, the rally’s age, and the deteriorating breadth as reasons to be alert to the potential for a 10% to 15% pullback. They also note that the September/October period is notorious for steep market declines.

And, “steep” is likely the operable word there. The adage that “the market takes the escalator up but the elevator down” seems to have been especially true in recent years. In recent years, I have enumerated several elemental factors in our modern-day market structure that suggest that, at least in their initial stages, market sell-offs are likely to continue to be steep. The high-frequency traders, who tend to provide liquidity and dampen market moves under normal conditions, tend to disappear when volatility spikes. Momentum traders, who keep buying as the market trends higher, will have stop-loss orders just below the market to limit losses. When those stops are triggered, it forces prices lower, triggering more stops. And, technical traders, who have been buying the market every time SPX fell to its 50-day moving average, will also rush for the exit if the index subsequently falls much below that level.

Even in the shadow of the cloud that settled over the market last week, there’s no reason to expect that any sort of pullback has to begin soon. However, given current conditions, it’s likely that, if the averages do find a way to climb to new highs, they’re likely to be just minimally higher highs. SPX ended last week near 4459; its 50-day moving average ended the week near 4424. Sustained trading below that level could very likely generate additional selling pressure. If the index then drops below its August low near 4368, that would substantiate that the market had likely just made an important intermediate-term top.

The potential for a 10% to 15% pullback is not a reason to take any drastic defensive actions, especially in light of the significant market gains over the past 18 months. Investors with cash on the sidelines should probably be cheering for such a buying opportunity. While the present situation may not be an opportune time to add risk to a portfolio, some investors might gravitate toward some of the newer investment products that provide a cushion of downside protection in exchange for capping upside potential. They should be aware that some firms consider such instruments to be complex products due to the sophisticated hedges that underlie the exposures.

The CPI data on Tuesday along with the Unemployment and Retail Sales numbers on Thursday are the reports that could most likely trigger a market reaction this week. Friday brings another of the quarterly quadruple expiration days on which options and futures on stocks and stock indices will expire. Such days are always among the highest volume days of the year, but not necessarily the most volatile.

Date Report Previous Consensus
Monday 9/13/2021 Treasury Statement, Monthly Deficit, August



Tuesday 9/14/2021 NFIB Small Business Optimism Index, August



Consumer Price Index, August, M/M



CPI, ex-Food & Energy, August, M/M



Wednesday 9/15/2021 Empire State Manufacturing Index, September



Import Prices, August, M/M



Export Prices, August, M/M



Industrial Production, August, M/M



Thursday 9/16/2021 Initial Jobless Claims



Philadelphia Fed Manufacturing Index, September



Retail Sales, August, M/M



Retail Sales, ex-Vehicles & Gas, August, M/M



Business Inventories, July, M/M



Friday 9/17/2021 Consumer Sentiment, September



Quarterly Quadruple Expiration of Stock and Index Options and Futures


Links to previously published commentaries can be found at benjaminfedwards.com/For Our Clients/Educational Resources/Market.