After stellar runs in both 2016 and 2017, the equity markets showed fatigue at the start of 2018. The S&P 500 Index and the Dow Jones Industrial Average ended the first quarter down 1.22 percent and 2.49 percent, respectively, while the Nasdaq Composite Index eked out a moderate gain of 2.32 percent.
All three averages were well into the green during the same period in 2017.
Will the pullback metamorphose into a full-blown bear market?
Although the uptrend in equities is still intact despite the first quarter's lackluster performance, confidence in the bull market has ended, according to Brad McMillan, the chief investment officer at the Commonwealth Financial Network, an independent broker-dealer based in Waltham, Massachusetts.
The deduction seems to be spot-on, going by the CNN Fear and Greed Index, or FGI, which takes into account seven factors to gauge investor sentiment. The FGI is now in extreme fear territory, with a value of 10. A year ago, the index was at 43.
The CBOE Volatility Index, another measure of investor sentiment, stands at 20.24, well above the 9-15 range at which it traded for most of 2017. In other words, the expectation of volatility is on the rise.
The consolation is that the VIX has come off its early February high of 37.32.
Source: Y Charts
Tariff Takes The Blame
The drop in February was due to the tariffs announced by the U.S., but the market bounced back on hopes that the trade measures are more of a negotiating tactic, McMillan said.
Selling re-emerged in March amid the disappearance of the blind confidence that took the markets upward in an uninterrupted path, the CIO said.
"In fact, the loss of confidence was so extreme that markets dropped down to one of the first long-term trend lines that often signals further trouble — the 200-day moving average," McMillan said.
On April 2, the S&P 500 closed below its 200-day moving average for the first time since June 2016.
Economic fundamentals haven't changed, with the economy continuing to grow,
A weaker dollar and robust overseas growth are boosting the manufacturing sector, McMillan said. And the Fed's intention to continue raising interest rates is a proof that the economy is doing well, he said.
The corporate income tax cut, strong corporate profit growth and increased federal spending make the market seem less expensive, McMillan said.
Geopolitical, Economic Concerns
Apart from the fallout of a potential trade war with China, McMillan said labor market tightness, slowing spending and the fleeting impact of tax cuts could spell trouble for the markets.
"The story of the past quarter was investors being forced to face the possibility that their confidence in the future might be excessive," McMillan said.
"The story of the second quarter will be how that plays out."
What's Denting Investor Confidence?
Investors have become more uncertain and less confident, as the focus shifts from the economy toward policy, the analyst said. The future has become even less certain, as the control is being taken away from the U.S. and China's response is brought into the picture, he said.
"By then trying to anticipate the effects on what companies are doing, the uncertainty ratchets up even further, and this is what is likely to have the biggest effects on the markets," McMillan said.
Despite the weakness, the S&P 500 Index has held up, steering clear of correction — which would mean a 10-percent crest-trough drop — and has bounced back after violating its 200-day moving average to the downside, McMillan said.
"It also remains vulnerable, though, to a more sustained loss of confidence, which is quite possible if the trade confrontation worsens, or if companies start reacting in the expectation that it will."
McMillan said he expects the volatility to continue, as the market is driven by policy rather than fundamentals.
Although the fundamentals have the potential to cushion any downside, what really worries investors is what is occurring in Washington, D.C. and Beijing, making them less confident, he said.
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