It was just two weeks ago that a number of year-end stock market forecasts were being revised upward, seduced by the siren song of tax reform and the giddy surge higher to start the year. But after the sharp reversal of the past two weeks, there is undoubtedly some regret in the haste to revise expectations higher.

In fairness, few were aware of the dangers lurking in the relatively obscure exchange traded notes that allowed investors to bet on stock market volatility remaining low, and the damage to the broader market they could inflict if circumstances moved against them, which is exactly what happened, with a vengeance. There is plenty of blame, however, for those making that bet. Not a day went by over the past six months without some mention of the extraordinary persistence of historically low volatility in stocks. During this interim, the VIX index of implied near-term S&P 500 index volatility averaged 10.6. This compares to its long-term average of 19.4. And yet, ignoring the compelling likelihood that this was an aberration, those traders were lulled into a dangerous complacency. Between the stock market high on January 26 and February 6 as the short-volatility trade blew up, the VIX surged from 11 to 50. Risk-parity strategies may also have been complicit, although not necessarily culpable, in the sharp drop in equities, as rising volatility forced the trimming of stock positions to balance their contribution to overall portfolio risk.

What Makes this Correction Different?

Whether the sudden move lower of the past two weeks has run its course is impossible to say. There may be other forced sellers who have yet to surface. But the S&P 500 did make a valiant turnaround on Friday after briefly piercing its two-hundred day moving average, to end the day higher by 1.5 percent. On the basis of closing prices, between the high on January 26 and the low on February 8, the S&P 500 dropped 10.2 percent, emphatically putting an end to all the talk of how long it had gone without experiencing a 3 or 5 percent selloff, never mind a bona fide 10 percent correction. On an intra-day basis, the selloff bottomed at midday on Friday, down almost 12 percent.

What is notable about this correction is that its proximate cause, namely wrong-footed short-volatility positioning, is not the real culprit. That distinction belongs to the more insidious rise in bond yields that spooked equity markets in the first place. The most recent move higher in bond yields has been underway since mid-December, when the ten-year treasury note yield was 2.40 percent and the two-year yield was 1.80. When stocks peaked six weeks later on January 26, these yields had climbed to 2.66 and 2.09 percent, a rise that was both noteworthy but also relatively orderly. Over the following week, however, these yields jumped to 2.84 and 2.16, as the Fed meeting was perceived as slightly more hawkish, and as increasing talk about rising inflationary pressures was inflamed by the January jobs report which showed the fastest rise in average hourly earnings in nine years, taking stocks lower in the process.

Economic Fundamentals Remain Strong

It is important to note that the fundamental backdrop for stocks remains encouraging. The economy is growing at the fastest pace of the recovery, enhanced by tax reform and the additional fiscal stimulus of the recent budget deal. Corporate earnings are surging. In response, stocks will most likely stabilize eventually and resume their climb. And maybe those revised year-end forecasts will prove to be prescient after all.

But while this long overdue correction makes stocks a little less pricey, the longer-term threat of rising bond yields is still very much with us. The risk of rising inflation in a full employment environment is meaningful, making Wednesday’s report on consumer prices the next market hurdle. But the prospect of rising bond market supply from expanding deficits and reduced central bank buying also risks pushing bond yields sharply higher. History tells us that not even a strong economy will be enough to prevent stock prices from falling in such a scenario.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
Past performance is not a guarantee of future results.
S&P 500 Index: Is an unmanaged capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.
Indexes are unmanaged and are not available for direct investment.
The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.
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