What’s Spooking Wall Street?

One thing is clear: Traders started hitting the “sell” button during the middle of this week. But the reason for the swift move lower in U.S. equity prices remains somewhat of a mystery.

The S&P 500 – a broad gauge of large-cap stock performance – swooned 2.7% this week in its biggest dive since June 2012. The turn to the downside has been sudden – with markets sustaining heavy selling Thursday and a solid drop Friday. The move has been accompanied with a 33.9% spike in the CBOE’s VIX, which is a closely-watched measure of volatility that’s often referred to as Wall Street’s fear gauge.

Moreover, Bank of America’s (NYSE:BAC) indicator of investor bearishness is running at its worst levels in more than a year and “more extreme than at the market lows of March 2009.”

Frequently selloffs can be pinned on a specific factor – geopolitical tumult, bad economic data, disappointing earnings, or any number of factors. This week has left many asset-management professionals offering disparate opinions on what exactly is making traders so nervous.

“The market is tired. We’ve had some all-time highs in the S&P 500 this month, and most of the days we had a high there were more stocks down than up,” said Bob Doll, chief equity strategist at Nuveen Asset Management.

Indeed, even with this week’s selloff, the S&P 500 is only a little bit more than 3% away from its record intra-day high, and up just about 4% for the year. That comes on the heels of the best year in 16 for the broad-market barometer.

Doll reckons Wall Street is “dealing with a transition” away from a market that is fueled by the Federal Reserve’s vast stimulus programs to one that is focused more closely on fundamentals.

“Now we have to rely on earning and they won’t go up 20% a year,” he said, cautioning that he doesn’t believe this is the end of the bull market that has marked the recovery from the worst financial crisis since the Great Depression.

Looking at the 376 S&P 500 components that have reported second-quarter earnings thus far, average per-share profit growth has come in at a moderate 7.5%, according to FactSet Research Systems (NYSE:FDS). However, 49 companies have issued disappointing current-quarter guidance, compared to 21 who have issued a positive outlook.

David Joy, chief market strategist at Ameriprise Financial, echoed Doll’s sentiment on the Street’s preparation for a world that isn’t propped up to the same extent by the powerful central bank.

“This is a wake-up call to some people who weren’t … thinking the Fed is any closer to tightening,” he said.

Joy is forecasting an early-summer 2015 rate hike – and is beginning to get concerned about rising inflation.

“One of the things the doves were failing to observe was that monetary policy works with a lag. It’s assumed to be six months until changes in policy … work their way into the system,” he said.

“So with the Fed being as aggressively stimulative as [it’s] been, the risk we run is that inflation could flare up and the Fed would be behind the curve pretty quickly.”

Still, not everyone thinks the Fed is behind this week’s selloff.

“If it was about the Fed, then why are rates down across the curve?” wondered Dan Greenhaus, chief global strategist at BTIG. He pointed to an instrument called Fed funds futures, which help traders bet and hedge against rate moves. The curve is actually slightly flatter than it was last week – indicating the market is pricing in a marginally-later rate hike (and certainly not an earlier one).

Adding credence to Greenhaus’s argument, the yield on the U.S. 10-year Treasury bond is little changed from last Thursday. Generally, yields would be expected to rise if investors thought a hike was coming sooner rather than later.

Given U.S. markets don’t live in a vacuum, Peter Boockvar, chief market analyst at The Lindsey Group, said concerns about Portugal’s embattled banking system could be weighing on sentiment. He also noted increased sanctions on Russia could reverberate through Europe’s economy and eventually ripple across the pond to America.

Doll and Joy both agreed tumult in Russia could be having a modest impact on sentiment, but still favored the Fed as the main culprit.

While the exact reason is a mystery, the turnaround in sentiment is worth keeping an eye on.