The late May market stumble cost the stock indexes just over 3% from May 21 to Monday's morning low - about the same degree of damage done by the two earlier setbacks this year, in February and April. Those ended up being sudden but fleeting stutter-steps in the S&P 500's unrelenting run to successive new all-time highs.
So will this little downside probe prove just as harmless in retrospect? A quick check of some of the market's subtler vital signs reveals no strong evidence of a decisive change in the benign upside trend. Yet subtler clues suggest a bit more risk that stocks are more vulnerable to further downside pressure or choppy action than earlier this year, including:
Increased urgency by sellers during this dip: Ryan Detrick, senior technical strategist at Schaeffer's Investment Research, has flagged an increase in the number of stocks undergoing "buying climaxes," in which they hit a new 52-week high but then closer lower to finish the same week. This implied an exhaustion of buyers energy and a profit-taking impulse spreading. Not a ringing verdict, but a cautionary pattern worth monitoring.
Unsettling tremors in global asset markets: The quicksilver, multiple-percent moves in Japanese stocks, gold's messy selloff, the swoon in some emerging-market currencies and rapid, disorderly jump in Japanese bond yields suggest some vulnerability to shocks and even some sort of "financial accident" from large players ill-positioned for the bumpiness. Such fibrillation evident across a range of world asset markets in the face of central-bank aggression and inconclusive economic trends are also somewhat unwelcome.
A need for new market leadership: The stock market has absorbed fundamental challenges before this year, largely by what I'm calling "immaculate rotation" from one segment of the market that's come under pressure into another ascendant class of stocks. Earlier this year, as economic data softened and emerging-markets and commodities suffered, "defensive" stocks such as utilities and household-goods companies coveted for their steady dividends were anointed and led the indexes upward. Another rotation is potentially stirring, into somewhat more cyclical stocks such as in industrials, financials and technology, now that the mad rush for "bond-like" dividend stocks has been thwarted for the moment. This will need to persist, which in turn requires a convincing improvement in the economic performance, which should make the prospect of reduced Fed help acceptable, after some possibly painful adjustment by investors. (Related: With Dividend Chase Skidding, Stocks Seek New Driver)
Technical Difficulties: Below the surface, some technically inclined market watchers detect some behavior that complicates the positive supply-and-demand setup that has prevailed since November. The running tally of rising stocks versus declining ones, known as market breadth, has weakened, implying at least a narrower advance. On Monday, an unusually low proportion of stocks rose even though the S&P 500 and Russell 2000 small-cap index each rose more than half a percent, which in the past has often preceded more volatility. The researchers at www.SentimenTrader.com note that the main measure of bond-market volatility, called the Merrill Lynch MOVE Index, has surged by far more the past month than has its equity-market counterpart, the CBOE S&P 500 Volatility Index. When these gauges of expected jumpiness have diverged this way over the last four years, it has tended to mean a bit more downside risk to stocks and a bounce in Treasury bonds was afoot. All of this, meanwhile, is occurring as investors' margin debt - or borrowings against investment portfolios - is at a record high.
The 'Yield' Sign: Stocks have been walked higher, re-pricing to be in line with stoutly valued corporate bonds. Historically, when a market has marched higher in each of the first five months of a year, as this one has, it has augured well, on average, for stocks in the coming months. The bump higher in Treasury yields in recent weeks and resulting lift in corporate-bond rates - even as they occurred for "good" reasons of rising economic confidence - raise questions about whether the gain led by dividend-centric stocks is over. Credit markets have held up OK, but have backed up a bit, removing one impetus for additional equity upside.
In the end, the backdrop for the 2013 rally is generally unchanged. All year, stocks have been supported by just enough evidence that that the domestic housing- and auto-led recovery was progressing, but not so fast that the Federal Reserve would imminently curtail its $85 billion monthly absorption of debt assets. (Related: 3 Things to Fear More Than the Fed)
But a lot needs to go right for the smooth rally path to last. So far this year, a lot has gone right, and each time a bit of a scare emerges, traders helpfully get skittish and complacency gives way to healthy anxiety. Yet given the rumblings beneath the surface, it's probably time to keep the market on a shorter leash.