Global assets fell into a "Black Monday" on Monday. The "US recession theory" that most people thought was premature earlier began to raise people's attention, that is, whether this year's red-hot stock market rally has gone too far.

Stocks from New York to London and Tokyo were hammered. Just as markets were beginning to celebrate the first signal of a rate cut from the Federal Reserve, U.S. stocks were hit by a perfect storm of weak economic data, disappointing corporate earnings, tight positioning and bad seasonal trends.

Although the S&P 500 recovered some of its losses, it suffered its biggest drop in about two years amid strong selling pressure. The tech-heavy Nasdaq 100 had its worst start to a month since 2008. Wall Street's "fear index" VIX once recorded its biggest gain since 1990.

U.S. Treasuries surged, with the two-year Treasury yield, which is sensitive to monetary policy, briefly ending its inversion with the 10-year Treasury yield, but then lost some momentum. Traders are betting that the U.S. economy is on the verge of a rapid deterioration and the Federal Reserve needs to start easing policy aggressively. The repricing was so large that the swap market earlier priced in a 60% chance of an emergency rate cut from the Fed in the coming week, although that probability has fallen.

“The economy is not in crisis, at least not yet, but we are in a danger zone,” said Callie Cox of Ritholtz Wealth Management. “If the Fed doesn’t better recognize the cracks in the job market, it risks losing its grip. It’s not broken yet, but it’s breaking, and the Fed could be behind the curve.”

Quincy Krosby of LPL Financial said valuations, sentiment and positioning are all stretched after such a strong rally. “What the market is experiencing is a liquidation of long positions,” she said. “The market is also looking at signs of Fed capitulation, evidence of economic growth and a successful test of the S&P 500’s 200-day moving average for signs of a bottom.”

The plunge in U.S. stocks vindicated some prominent bears who doubled down on warnings about the risks of a slowing economy. JPMorgan Chase's Mislav Matejka said stocks will continue to be pressured by weak business activity, falling bond yields and a deteriorating earnings outlook. Morgan Stanley's Michael Wilson warned that the risk-reward ratio is "unfavorable."

“This does not look like the ‘recovery’ backdrop one had hoped for,” Matejka wrote, adding that “we remain cautious on equities and expect a ‘bad news is bad news’ phase to set in.”

Seema Shah of Principal Asset Management believes that concerns about economic weakness may prove to be overdone, but the current depth of negative rhetoric means that an immediate turnaround is unlikely. A sustained market recovery would require a catalyst, or perhaps a combination of catalysts, including a stabilization of the yen, strong earnings data and reliable data releases.

Maxwell Grinacoff of UBS Investment Bank noted, “Similar to what we saw a few weeks ago in the small-cap rotation, tight positioning has clearly heightened the level of volatility. The difference today is that the elevated level of risk premium is fundamentally supported from a macro and earnings perspective.”

Keith Lerner of Truist Advisory Services said that after a very strong first half of the year, the market has risen a lot on a short-term basis, the threshold for positive surprises is too high, and the impact of a little bad news can be large.

“From a stock market perspective, our base case has not changed," Lerner said. "Our research still suggests the bull case is questionable. However, given the sharp rally in April, nervous sentiment, and the fact that we are entering a seasonally weak time of year, we had been expecting a more volatile environment in July and the second half of August.”

Furthermore, after a strong first half of the year, historically, stocks typically experience a 9% correction at some point, even if the market still tends to move higher into the year end.

It is worth noting that over the past 40 years, the average maximum annual correction of the S&P 500 index was 14%. Despite this, Lerner said, the average return of the stock market (excluding compounding) was still 13%, and it was up in 33 of the 40 years, accounting for 83% of the total time. Lerner added:

“While always unsettling and usually accompanied by bad news, a pullback is a ticket into the stock market, which is what offers the potential for higher long-term returns relative to most other asset classes.”

Russell Price of Ameriprise said investors should think rationally about the current situation. Are markets correcting because they may have seen stocks rise too far too fast? Or are markets falling because of real threats to economic conditions and the possibility of a global recession?

“We think the evidence overwhelmingly supports the former,” Price said. “The U.S. economy is currently slowing to more sustainable rates, but we don’t think a near-term recession is the most likely path forward. Even if it is, we think the Fed has enough firepower to lower rates to stimulate economic activity if necessary, which should again attract capital to equities.”

John Lynch of American Wealth Management said that when investors turn their calendars to August, they may also change their views on the economy. He said, "In less than two weeks since the second quarter GDP report unexpectedly rose, the stock market has been hovering near record highs, but there is a growing view that the Fed has waited too long to cut interest rates and is now behind the curve. While we are not completely convinced by the new narrative, one thing seems certain, that is, there will be more volatility ahead." Systematic funds have sold more than $130 billion of global stock market bets in recent weeks. Now, with volatility soaring, these rule-based players may take their selling to a whole new level.

Morgan Stanley's trading team estimates that strategies including risk parity, volatility targeting and trend following sold $70 billion to $80 billion of stocks on Monday, and at least another $90 billion of stocks will be sold over the next four trading days.

For Bank of America's Michael Gapen, the market is once again getting ahead of the Fed. Jeff Schulze of ClearBridge Investments said a key question for investors is whether this rotation will continue or peter out as it has before.

As the sell-off in global equities intensified on Monday, JPMorgan Chase & Co.’s trading desk said the rotation out of technology stocks may be “largely complete” and the market is “approaching” a tactical opportunity to buy on dips.

JPMorgan's position intelligence team wrote in a note to clients on Monday that retail investor purchases of stocks have slowed rapidly, trend-following commodity trading advisors have slashed their positions in the stock region, and hedge funds have been net sellers of U.S. stocks. "Overall, we believe we are approaching a tactical opportunity to buy on dips," wrote John Schlegel, head of JPMorgan's position intelligence. "Nevertheless, whether we see a strong rebound may depend on future macro data."

Paul Nolte of Murphy & Sylvest Wealth Management said:

“The euphoria of the first quarter is quickly becoming a distant memory as weaker economic data is raising calls for the Fed to cut rates soon, perhaps before its next meeting. We are in the early stages of the ‘dog days’ and things are heating up on Wall Street.

Article forwarded from: Jinshi Data