A few days ago, the Nasdaq dropped into correction territory. That is when the market falls more than 10% from the most recent high. Because the Nasdaq is heavily weighted in tech stocks, many analysts explained this move as a 'rebalancing' away from higher valuation stocks to more growth stocks.

The general theory was that stocks with higher valuations, like tech stocks, wouldn't be as interesting for investors once the cost of borrowing money rose. Instead, they would prefer industrial stocks that had lower valuations and higher dividend yields to offset the capital costs of holding the stock.

Some theories come to an end

However, the S&P 500, which is generally seen as the benchmark index comprising a wider range of stocks from all sectors, was moving lower during the same period. In fact, the S&P 500 hit a new record on the first day of trading this year, and since then has pretty much been heading downward.

On Friday, the index hit the dubious milestone of breaking below the 200-day moving average. That doesn't suggest that investors are moving from tech to industrials, so much as investors are moving out of everything and into more safe investments.


There are good reasons

Naturally, the move can be explained by several factors.

The increasing geopolitical tensions, particularly around Ukraine, would normally keep investors cautious. On top of that is the expectation that the Fed will raise rates at their next meeting, making it more expensive for investors to borrow money. Then there was the issue of potential future increased spending being shelved, as the Build Back Better bill was effectively terminated. And, of course, there was also the depressing December jobs report.

There are plenty of fundamental reasons to be less than optimistic. However, retracements to, and minor incursions below, the 200 SMA aren't unusual. Markets tend to like to "fill the gaps". That means to retrace to a prior high after making a new high. So, a move lower for a period of time could potentially simply be a "buy the dip" opportunity.

Why the 200 SMA is important

There isn't anything magical about the daily 200 SMA. It just happens to be the most common indicator used by analysts, economists and traders to gauge the long-term trend in the market.

Generally, and most of the time, the trend is higher. So, when the market retraces back to the 200 SMA, it grabs the attention of a lot of traders. Some might reevaluate their positions and outlook as a consequence.

Many see the moving average as an indicator of whether the market is simply correcting and then heading higher. Or alternatively, it can show whether it will enter a bear market and start trending lower for an extended period.

It is fairly common for the S&P 500 to "bounce" off the 200 SMA, and then track back to new highs. In fact, it has bounced off the indicator twice since the start of the pandemic recovery.

History rhymes if not repeats

However, the last time the Fed started ratcheting up rates (also under Powell), the S&P broke below the 200 SMA, and then just kept on going. It spent the next three months moving lower, until the Fed finally desisted from their tightening schedule.

While we are comparing, the Nasdaq also broke through the 200 SMA this month and has subsequently kept moving lower.

This is what some technical analysts call a "hibernating bear". That is, as a bull pushes the market upward, a correction is inevitable. The correction can then push back to the 200 SMA. And the momentum can shift to being bearish, effectively "waking up" the "hibernating" bear that has been building over the last months of rampant growth.

Typically, this happens when the market rises over 30% in a matter of months, and then moves back a similar amount in a matter of weeks.

Buy the dip implies it's a dip

How do we know which one is it?

The fundamentals of the economy are overall favorable. However, there could be a mismatch in optimism. That said, while the numbers are good, they might not be as good as the market is pricing in. This means that a correction is in order, and the market will resume its upward trajectory once it has 'rebalanced', assuming the theory is correct.

On the other hand, rising inflation could have led to a shift in the economy's behavior as people are faced with less purchasing power and businesses are about to see higher capital costs.

The economy could keep growing. However, it's possible the stock market "priced in" too much growth too early. The combination of tighter economic policy plus economic uncertainty around the effects of omicron could lead to the markets drifting lower for a while.

What to look out for

Measures of consumer sentiment could give us some insight as to whether inflation is having a negative impact on people's buying habits.

Durable goods orders should help us figure out if businesses are seeing an impact on their capital costs, as they decide whether to make large investments that will pay off in the future. The GDP number could be important, but it's a lagging indicator, measuring what happened last quarter.

As we get through earnings season, we'll get a better understanding of corporate guidance, and whether businesses are expecting their sales to improve. Those data points coming out in the upcoming days could be pivotal in understanding where the market could be headed.

This article was submitted by Orbex.