Bearish sentiment lingers in the US stock market, "buying the dip" still carries risks

The U.S. stock market has experienced a significant pullback for the first time in six months. Should one buy on dips now or wait and see? After weeks of turbulence, the S&P 500 index has dropped more than 5% from its closing high on March 28, the largest decline since October last year. An analysis by a U.S. bank shows that since 1929, the S&P 500 index experiences an average of three pullbacks of 5% or more each year. Despite the recent months of stock market growth, such a decline is not uncommon.

Many market participants believe that the factors that drove a 10% increase in the S&P 500 index in the first quarter, including the resilience of U.S. economic growth and excitement about artificial intelligence, still exist and will support the stock market in the long term. However, last week saw a shift in favor of sellers. The S&P 500 index fell for the sixth consecutive trading day last Friday, marking the longest continuous decline since October 2022.

Analysts say the stock market pullback is "normal," with some investors starting to buy on dips

While some investors have started buying on dips, others are waiting for clearer trends in inflation, geopolitical tensions in the Middle East, and corporate earnings before re-entering the market.

King Lip, Chief Strategist at wealth management firm Baker Avenue Wealth Management, said, "The pullback was overdue. I think this is a routine adjustment." Lip has started increasing stock exposure for clients and plans to buy more stocks as the stock market further declines. However, he believes the S&P 500 index may drop at most 10% from its high on March 28.

History shows that after a strong start to the year, there is often a significant decline, followed by a self-correction and continued upward trend in the stock market. A study by Truist Advisor Services shows that when the S&P 500 index rises by 10% or more in the first quarter, there is an average maximum decline of 11%. However, out of 11 such events since 1950, the index closed higher in 10 of them.

Sonu Varghese, Global Macro Strategist at Carson Group, said, "We are not surprised by a slight pullback in the stock market, and I believe buyers will start entering." He has been increasing positions in small-cap stocks during the recent softening of the stock market.

Despite this, investors are becoming more cautious. U.S. Bank reported last Tuesday that its clients sold $800 million worth of U.S. stocks in the past week, marking the third consecutive week of net selling. At the same time, some volatility-sensitive funds that bought stocks during the market rally have started selling. If the market becomes more volatile, they may sell more stocksNomura Securities analysts estimate that if the daily average volatility of the S&P 500 index in the next two weeks is 1%, these volatility control funds may sell stocks worth about $45 billion.

Investors are also watching the level of the Chicago Board Options Exchange (CBOE) Volatility Index (VIX). Despite the index being near a six-month high of 19, some volatility observers believe that the index does not fully reflect recent inflation concerns and geopolitical turmoil that have caused market panic in the past few weeks. Seth Hickle, managing partner of Mindset Wealth Management, stated: "Given the potential escalation of the situation in the Middle East, I am surprised that short-term volatility has not increased further. We have reallocated a small portion of our positions, but I will wait to see how earnings play out before making any significant adjustments to our portfolio."

Market participants also say that while the selling scale of volatility control funds is insignificant compared to the $42 trillion market value of the S&P 500 index, the tendency of these funds to follow market trends can sometimes exaggerate market movements. If volatility rises, other slower-moving strategy funds may also join in.

Compared to other computer-driven strategies, the "trigger mechanism" of volatility control funds is relatively fast, making them one of the first funds to react to changes in market conditions. A more pronounced increase in volatility may also stimulate slower-reacting funds, which use volatility as a trading signal, including Commodity Trading Advisors (CTAs) and risk parity funds, to increase selling pressure and bring greater pressure to the market.

McElligott of Nomura Securities pointed out that if the S&P 500 index falls another 2% to around 4914 points in the coming weeks, CTAs may sell about $31 billion worth of stocks. McElligott said: "So far, volatility control has been a bigger driver in systematic deleveraging... during this volatile pullback. If the economy remains weak, CTAs will join the ranks in the coming weeks."

Pressure on Financial Reports Season to "Rise to the Challenge"

As the released earnings reports fail to satisfy investors, the baton will be passed to one of the strongest performing sectors in the market over the past year: large tech companies. In fact, many believe that the upcoming earnings of some large companies in the market in the next week may provide support for the stock market—or further exacerbate selling. Tesla (TSLA.US), Meta (META.US), Alphabet (GOOGL.US), and Microsoft (MSFT.US) all plan to release reports in the coming daysSo far, the profitability of the companies that have been announced is mixed. Netflix (NFLX.US) plans to stop disclosing subscription numbers starting in 2025, raising concerns about growth, causing the company's stock price to fall last Friday, while the world's largest contract chipmaker, Taiwan Semiconductor Manufacturing Company (TSM.US), lowered its expectations for industry growth.

Quincy Krosby, Chief Global Strategist at LPL Financial, wrote in a report on Friday: "As the forward P/E ratio of the S&P 500 index still exceeds 20 times... if the earnings of large tech stocks disappoint, it may further push this week's oversold market into an even more oversold state."

Considering the significant rise in the stock prices of some market darlings this year, optimistic expectations have been digested, so even earnings that exceed expectations may not impact the stock market. Julian Emanuel, Head of Stock, Derivative, and Quantitative Strategy at Evercore ISI, stated: "There has been digestion in the broader market around this earnings season."

Previously, the market's reaction after 65 S&P 500 index component companies announced quarterly results on the second day was generally the same. Emanuel's research shows that stocks that beat Wall Street's expectations rose by 0.8% on the next trading day, slightly lower than the average increase of 0.9% in recent years.

Meanwhile, companies that disappoint in both revenue and profit face a greater impact than usual; their stock prices on average fell by 5.8% in the next trading session, compared to the usual 3.1% decline over the past five years. Emanuel said: "Given the overvaluation of the S&P 500 index, even good news may not be good news, especially for companies that have come this far."

FactSet pointed out last Friday that the earnings of the aforementioned tech giants, as well as NVIDIA (NVDA.US) and Amazon (AMZN.US), are expected to grow by 64.3% in the first quarter of this year. Earnings for the other 495 companies are expected to decline by 6%.

Inflation Stickiness Remains a Concern

Unstable inflation data over the past few months has led investors to lower their expectations for a Fed rate cut this year. Chicago Fed President Charles Evans stated last Friday that "progress on inflation has stalled."The central bank's wait-and-see approach for clearer inflation trends is considered "reasonable". This makes the US March PCE price index, to be released on Friday, even more crucial as it is an important inflation data before the Fed's interest rate meeting on April 30th to May 1st. Recently, stronger-than-expected inflation data have weakened a key driver of the bull market, with investors currently expecting a rate cut of about 40 basis points this year and a projected 150 basis points cut by early 2024.

Economists expect that with the rise in energy costs, the overall PCE price index in March will increase by 2.6% year-on-year; the March "core" PCE price index is expected to grow by 2.7% year-on-year, lower than the 2.8% annual growth rate in February. Economists anticipate a 0.3% month-on-month increase in the "core" PCE price index, consistent with the change from the previous month.

Although the core PCE price index may not be as strong as the previously released March Consumer Price Index (CPI), Federal Reserve Chairman Powell and other officials have indicated that they need more time to gain confidence in the downward trajectory of inflation before considering a rate cut. The Consumer Price Index exceeded expectations earlier this month, causing unease in the market. This suggests that Fed officials seem poised to receive further confirmation that progress against inflation has stalled, which seems to support a shift in the Fed's tone to maintaining high rates for longer than previously expected.

Tim Ghriskey, Senior Portfolio Strategist at Ingalls & Snyder in New York, stated that he has "made some buy-the-dip moves in very aggressive portfolios" but remains concerned about the upcoming inflation data. He said that to avoid concerns about Fed rate hikes, "restoring anti-inflation is key".