Why the Stock Market Drop Is Far From Over

Retail sales were part of the problem, as higher-than-expected spending led to worries that inflation will remain hot and prevent the Federal Reserve from lowering interest rates. Escalating tensions in the Middle East between Iran and Israel were also making investors nervous.

And with good reason.

“Equities are caught between a strong, inflation-enabling US economy and worries of a wider Mideast conflict that creates the preconditions for a recession,” writes DataTrek Co-Founder Nicholas Rabe.

In a Tuesday note, he points out that the

CBOE Volatility Index,

which measures implied volatility and is often referred to as the market’s fear gage, closed at 19.2 on Monday. While that marked a surge for the day, it was still short of the long-run average level of 20, along with the one-year closing high of 21.7 seen during the market’s October lows.

The fact that the VIX isn’t close to its high even with these increased worries “tells us that markets will likely remain volatile over the next few days at least,” he warns.

Likewise,

Charles Schwab
’s

Director of Derivatives Analysis Nathan Peterson noted on Tuesday that after the S&P 500 saw “dramatic losses” in three of the last four trading days, the index is now below its 5-day moving average for the first time since November.

That’s a “sign of technical weakness with potential spillover today. Lack of any late buying interest yesterday suggests that ‘buy the dip’ sentiment may be fading,” he writes. “The S&P 500 is now within shouting distance of its first 5% drop from highs since last October.”

At this point, the S&P 500 is off about 3.7% for the month of April. But after a first quarter for the record books, the index is still up more than 6% for the year.

That might provide comfort to some, but Marko Kolanovic, head of

J.P. Morgan
’s

global market strategy team warns of a “disconnect” between equities and the mounting potential headwinds.

“For a market reliant on immaculate disinflation, a dovish Fed reaction function, and diminishing tail risks on growth, the continuation of hot growth and inflation data can bring us to a tipping point where a tighter stock vs bond risk premium finally produces a market correction,” he writes. “Inflation risks are also compounded by upside risks to oil due to geopolitical developments related to Russia and risk of further escalation in the Middle East. Additionally, investor positioning is elevated, with cash allocations at historical lows.”

That leads him to remain defensive in his positioning, underweighting equities in favor of commodities and cash.

Vermilion Research Global Strategist Ross LaDuke doesn’t think that investors should panic yet—but says that there are warning signs flashing. He writes that he would need to see the S&P 500 and

Nasdaq 100

close below their 20-day moving average and 21-day exponential moving average—with the latter giving more weight to current data—for more than two to three consecutive days to get more cautious.

Monday and Friday were two consecutive days, so “caution is warranted,” he writes.

Nonetheless, he argues that in order for a more meaningful pullback, current two-month supports levels—i.e. around 4983 to 5050 points for the S&P 500—that are being tested now would have to break to allow for bigger declines. “Only then would it open up the possibility for the S&P 500 to move toward major support at 4800. And it is important to note that, even if that scenario plays out, we would view it as a buying opportunity.”

So long-term investors, rejoice. But don’t forget to buckle up.

Corrections & Amplifications: Charles Schwab’s Director of Derivatives Analysis Nathan Peterson wrote a Tuesday markets note quoted in this article. An earlier version of this article incorrectly attributed the quotes to Charles Schwab director Joe Mazzola. 

Write to Teresa Rivas at teresa.rivas@barrons.com