Eight-Week Stock Market Rally Ends With Tax Jitters on the Rise

(Bloomberg) -- So the stock market actually can go down.

U.S. equities posted the first weekly loss in more than two months as investors turned leery after congressional Republicans made little progress in passing tax cuts. Shares that would benefit most from a lower levy burden led declines, though selling spread to economically sensitive stocks as credit markets flashed warnings signs about the pace of growth.

“Doubt starts to creep into investors’ minds about what the tax plan is going to be,” said Mark Kepner, managing director and equity trader at Themis Trading LLC in Chatham, New Jersey, noting the market still looks good, regardless. “This week’s dip is a healthy retreat given the rally we’ve had so far.”

The S&P 500 Index slumped 0.2 percent in the five days, finishing at 2,582.3. The bulk of the losses came in the final two sessions after the gauge closed at a fresh record high Wednesday, six points shy of 2,600. Small caps in the Russell 2000 Index fell 1.3 percent for a third week of declines. The Cboe VIX Index rose 23 percent, the most since the five days ended Aug. 11.

The S&P 500’s failed run at a new round-number milestone added to selling pressure Thursday, as investors concerned about the prospects for tax cuts took the chance to get out of an equity market that has gone longer than ever without a slump of 3 percent. 

While analysts debate how much the market has priced in tax reform, stocks reacted to headlines indicating cuts might not be as deep or come as soon as expected. The Senate’s version issued Thursday departed in meaningful ways from the House’s, especially on the timing for corporate tax cuts. That exacerbated weakness in small caps, which are poised to benefit most from a corporate tax reduction.

Bank stocks also took a hit, ending the week down more than 4 percent, as lower corporate taxes that bolster investment would be boon to lenders. Adding to troubles for the banks was the flattest yield curve in a decade, which would wear on already weak interest income at the nation’s largest lenders. At the same time, high-yield corporate bonds tumbled in the week, with yields spiking for some of the riskiest debt. An exchange-traded fund that tracks junk debt had its worst week since August.

Even with the first decline in weeks, strategists underline the fact that this week was far from awful. The S&P 500, Nasdaq, and Dow Jones Industrial Average all hit fresh highs Wednesday, but with most U.S. companies done reporting earnings and almost all bears already having turned bulls, the market may be short of reasons to continue the upward march for now.

“The uncertainty over the tax reform weighs on the market, but technically the market was prone for a pause as investor sentiment has been very optimistic for quite some time,” said Bruce Bittles, chief investment strategist at Robert W Baird. “The S&P isn’t much lower than where it was last Friday, I wouldn’t expect a major surprise to the downside as long as the interest rates in the long end of the curve behave.”

And while the Russell 2000 has fallen more than 2 percent in the past three weeks as tax reforms chances have dimmed, there are signs the selling may have peaked. The cost to hedge against losses in an exchange-traded fund tracking the smaller companies is at the lowest level since March.

Still, the selling later in the week unnerved investors who’ve grown accustomed to one of the calmest markets in history. Volatility rushed back, with the VIX, a gauge which uses options-trading data to measure implied volatility of S&P 500 stocks, ending the week just above its 2017 average after hitting a record low just last week.

This could be the beginning of a push to move back to normal from a year that has been characterized by freakish calm, according Eric Aanes, President of Titus Wealth Management in California.

“It’s just been calm, dead, the VIX is at all-time lows of history and now all of a sudden in the past couple days it’s spiking up,” he said by phone. And as long as tax reform contention continues, volatility could be here to stay.

“Is it going to spike up back to normal? Is it going to drop back down into calmness again? We don’t think so,” Aanes said. “The VIX spiking up is starting to tell the market things are not OK, and we need to have some serious caution moving forward.”

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