Anatomy of a Fragile Market: What to Make of Stocks

By Michael Santoli

"Christmas in July" is celebrated by families in parts of the Southern Hemisphere and by hucksterish retail chains above the equator. Right now the stock market is experiencing a bit of July at Thanksgiving, its recent downturn producing market conditions last seen in late July, when a sharp, two-month selloff was running its course before a two-month rally got underway.

The Standard & Poor's 500 Index has fallen 7.7% to 1353 in the two months since its multi-year peak of 1465 on Sept. 13, dragged lower by flagging corporate-profit performance and, of course, the rampant anxiety about the tax-and-spending standoff in Washington. The last time the index was in this immediate neighborhood was July 26, when it closed at 1360, having already dropped 10% to 1278 in May and June. During this summer retreat, investors were consumed with the threat of an economic slowdown here and in China, as well as European authorities' ability to counter the debt crisis there.

Here's a comparison of the market's posture and gait in both periods, using a quick survey of some below-the-surface trading indicators.

First, the bad news. On a daily basis the market has traded quite sloppily, showing a dispiriting inability to hold on to morning rallies and a tendency to sag later in the day. For seven straight sessions, the S&P 500 has finished in the lower half of its daily range.

This isn't a foolproof hint of a nasty washout to come, but it emphasizes how little buying energy the market has been running on since even before the presidential election sharpened the focus on the "fiscal cliff" and soured investor sentiment. Even if a hard-headed assessment of the probability of a fiscal resolution with sober estimates of long-term effects yield few disaster scenarios (See: "3 Reasons to Fade a Fiscal-Cliff Freak Out"), the longer we go with the public obsessing over it in a substance vacuum the more it could invite a cascade of anxious selling.

The headline S&P 500 is now as "oversold" — or as far below its intermediate-term trend - as it was at the market lows in late spring, and all 10 of its industry sectors are appreciably below their three-month trajectory. When such extremes are reached, it tends to mean that the market should soon at least bounce, and if it doesn't, the decline could get out of hand quickly.

The relatively orderly, if oppressive, tone of the correction has so far prevented the sort of visceral, climactic panic selling that frequently marks the final "give-up" phase of a market retrenchment.

The weekly market-sentiment poll by the American Association of Individual Investors release Thursday showed a welling up of concern among the public, with avowed bears outnumbering market optimists 48% to 28%, similar to the 43%-28% split the third week in July. This is faintly encouraging, as bearishness usually peaks as stocks reach a trading bottom.

Yet it has gone much remarked that the S&P 500 VIX index (^VIX) of protective-options pricing has remained unusually subdued during the market drop, defying its typical tendency to surge in nasty markets along with investor fear. While this could imply that sophisticated traders are loath to price in major immediate losses, similar action in the past has also occurred in the midst of treacherous bear markets such as in 2000.

A lesser point is that markets bounced back in August and September in part on faith that the Federal Reserve would deliver a fresh round of asset buying with conjured money. No such hope pervades trading desks today, even if the Fed would certainly not sit mute or still if fiscal tightening began smothering the recovery.

With these important cautionary observations noted and heeded, it remains interesting that a variety of signs from around the capital markets are holding up a bit better than the broad market benchmarks, and are raising fewer alarms about underlying economic prospects.

When last the S&P 500 was within points of Thursday's closing level in late July, for instance, the 10-year Treasury note yield (^TNX) was 1.43% versus 1.59% now. The lower the yield, the greater the bond market's implied concern abut economic slowdown, so this is a modest net positive in favor of today's backdrop. Indicators of credit health such as "junk" bond spreads have weakened but remain stronger today than in the depths of summer. Fixed-income markets, in short, are far from agitated about the chance of runaway financial contagion as were did in the worst market skids of the past three years.

The worst of the damage, too, has been localized in large, domestic stocks. The German DAX index (^GDAXY) and the iShares FTSE 25 index fund (FXI) are both well above where they were when the S&P was in the same spot. The Guggenheim S&P 500 Equal-Weight index fund (RSP), which effectively tracks how the "average" stock is doing, is 4% higher with the traditional market-value-weighted S&P 500 flat. Sectors geared to economic momentum such as industrial and consumer-discretionary, which typically lag in a skittish tape, are outperforming the benchmark.

One likely reason for this unusual interaction of market vital signs is investors' frightened, reflex selling of normally defensive, high-dividend stocks in the telecommunications, utility and consumer-staples groups in advance of potential increases in dividend and capital-gains taxes as the Bush tax provisions approach expiration.

So these sectors, normally ballast in a market storm, are weighing down the broad index more heavily than usual, making the headline losses worse without transmitting a message that collective market wisdom is pricing in greater economic risk.

This is perhaps a thin reed for would-be dip buyers to grasp amid such a foreboding swirl of headlines and confidence-sapping market action. At such times, though, the reeds always seem to be pretty fragile, yet sometimes they fail to break.