The Super Rally in Stocks Starts to Show Cracks

(Bloomberg) -- Rarely do 2 percent pullbacks feel this scary.

Seven days into May, and while the stock market’s 2019 miracle remains intact, it’s starting to show cracks. A hundred words of Donald Trump tariff tweeting has quickly become $500 billion in value erased in the S&P 500. Dread is creeping in. The index is down 2.1 percent in the five days since Federal Reserve Chairman Jerome Powell played down hopes for a rate cut.

All along, as stocks surged, a question has loomed: how would the traumas of last year affect the psychology of today once the market’s straight-up trajectory wavered? For most of 2019 investors have seemed inured to cataclysm, convinced they’d seen the worst and come through alive. After Tuesday, they sounded a little less sure.

“There certainly is that little voice in the back of your head saying, ‘Uh oh, here we go again,”’ said Delores Rubin, a senior equity trader at Deutsche Bank Wealth Management. “There is this little bit of fear that, OK, let’s take what we’ve got and not end up losing for the year, like everyone did at the end of the year last year.”’

Stocks capped the biggest two-day slump since early January Tuesday, with the S&P 500 falling 1.7 percent. Testifying to the stress traders have felt, demand for protection against further losses surged above any level in the fourth quarter in the options market Tuesday. At one point, the volume of shares falling was higher than on Christmas Eve, one of last year’s worst sessions.

To be sure, the events of the last two days reverse only a fraction of this year’s advance and come nowhere near the panic of last year’s routs. But they feel new next to the almost uninterrupted gains of the last four months. As of Friday, the Nasdaq 100 had climbed in 18 of the last 19 weeks, a feat of consistent upward grind that didn’t even happen in 1999, a year the index doubled.

“Is 1.5 percent or 400 Dow points a lot? Yeah, it’s a lot. It’s not insignificant,” said Ernie Cecilia, chief investment officer at Bryn Mawr Trust Co. “But you have to realize, too, the market has come back and regained virtually all it had lost in the fourth quarter.”

However small the dent, it’s confirmation that investors remain ultra-sensitive to last year’s biggest bugaboos: rates and trade. Bulls absorbed a warning shot last week when Powell said weakening price pressures might prove transitory, sending the S&P 500 to its worse loss in more than a month. Shares have done nothing but fall since Trump warned of higher tariffs on China.

Premonitions of a repeat of last year have informed a fair amount of investor behavior already in 2019. Inflows to stock funds have been dwarfed by those to bonds, and professional managers have been reluctant to go all in. In late April, hedge fund equity exposure stood in the 22nd percentile over the past year, with bullish bets outpacing bearish ones by a relatively paltry 1.6-to-1, data from JPMorgan’s prime brokerage unit showed.

“The wounds from December are still fresh,” said Frank Ingarra, head trader at Greenwich, Connecticut-based NorthCoast Asset Management LLC, which oversees $1.8 billion. “If you think about retail investors who lived through December and probably got absolutely crushed, they’re feeling pretty good right now and they’re scared the trade-related selloff is going to take the market’s gains away from them.”

The connection to last year’s traumas is heightened by goings on in pockets of the market that created trouble in 2018. Market geeks are noting that futures tied to equity turbulence over the 30 days are suddenly pricing in a lot more pain than those pegged to several months hence, a curve inversion that preceded last year’s downdrafts.

More than 70 million shares in both the VelocityShares Daily 2x VIX Short Term ETN and iPath Series B S&P 500 VIX Short-Term Futures ETN crossed the tape in New York trading on Tuesday, boosting volumes to an all-time high, data compiled by Bloomberg show.

Also present is the political discord that was a backdrop to last year’s market stress. While it’s hard to trace direct effect, an emboldened progressive wing of the Democratic party has turned its sights on policies many investors saw as market-friendly. Bernie Sanders has proposed all but banning stock buybacks. On Monday Senator Kamala Harris said she’d seek to repeal all of Trump’s 2017 tax overhaul, including breaks for corporations.

“There’s a bigger issue here beyond just the trade war itself,” Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, said in an interview at Bloomberg’s New York headquarters. “I do worry a little bit as we head into the summer that we’re entering into this period in which political uncertainty is going to be elevated. And when that happens, you usually do see stock market volatility pick up.”

©2019 Bloomberg L.P.