6 reasons why this selloff is just getting started

Opinion: North Korea may not be the biggest worry for this ailing stock market

Michael Bush

Did Thursday's little jolt of volatility wake you up after months of unusual stock market calm? Better get used to it.

You might be tempted to think that the conflict between President Donald Trump and North Korean leader Kim Jong-un was the main cause of the selling. If so, you probably have faith that as soon as this calms down we can get back to the races. Given that Trump has lots of supporters who are invested in stocks, there’s extra motivation for him to behave in a way that calms the markets. Right?

The problem with this theory is that Thursday's weakness in the Dow Jones Industrial Average DJIA, +0.07% , the S&P 500 SPX, +0.13% and the Nasdaq COMP, +0.64% , actually may not have a lot to do with U.S.-North Korea saber-rattling.

Instead, what's really going on is that the conditions were there to make the market extra vulnerable to a catalyst like the North Korea nuke squabble. And those conditions have not gone away. So there's more to come. "I think this is a correction that's not over," says Doug Ramsey, the chief investment officer of the Leuthold Group. Here are six reasons why Ramsey may be right.

1. August is the cruelest month, but September and October aren't great either

We're in what's normally the worst time of the year for the stock market. August is historically the most volatile month. It's starting to live up to its reputation. The deepest market selloffs often happen in September and October. No one knows exactly why this is, but it probably has to do with a psychological need ingrained in us by evolution to harvest, hunker down, and get more cautious as the weather cools. Studies show that this pattern happens in both hemispheres — where the seasons are flipped.

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1. Hello, is Marge in?

People who run margin departments at brokerages have to be among the cruelest people in the world. When times are good, they relax standards and dangle lots of available margin in front of you. When everyone around you is bullish and stocks go nowhere but up, it's tempting to use it. So maybe you do.

But then the moment volatility picks up, the margin sadomasochists increase margin requirements on stocks, thereby cutting back on available margin. If you are on margin, what you thought was a reasonably comfortable level of safety can turn into a margin call pretty quick.

That's happening now. With margin debt at near record levels, this problem could snowball. Investors selling stocks to meet margin calls could push stocks down more, triggering more margin calls and therefore more margin-related selling.
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1. Market internals are crumbling

Technicians love to look for "divergences" inside the market that signal a directional shift. If most stocks or stock groups are moving higher as the narrower indices like the S&P 500 march ahead, all is good. No divergences. But when narrow indices continue higher while fewer stocks participate, that's not good. It's a troubling divergence. And that's what's been happening lately.

While the Nasdaq continued higher last week, the number of stocks hitting new lows spiked and the new highs list narrowed, points out Baird investment strategist William Delwiche. He sees the same deterioration of market breadth at the sector level. "This supports the view that index-level weakness is not strictly a reaction to geo-political tensions, even if that provided the initial impetus for selling," he says.

1. A troubling twist in investor sentiment

Investor sentiment has been high for weeks, and this in itself is troubling. When everyone is bullish there are fewer people left to buy and push your stocks higher. Overly confident investors are more vulnerable to "surprises," since they complacently think that nothing can go wrong.

But often, the real trouble for stocks doesn't begin when sentiment hits highs, but when sentiment starts to roll over after a long stretch of strength. That's what's happening now. "When sentiment reverses at an extreme, it usually pays to take a contrarian position," Delwiche says.

1. ‘Unlucky 7’

This is a weird one which I can't explain. But even if this signal seems like something right out of astrology, it's still troubling.

Over the past 100 years, during years ending in seven, the market has almost always been a train wreck during the late summer and fall, points out Ramsey at the Leuthold Group, who brought this odd indicator to my attention. "We wouldn’t vacate the stock market based on this pattern alone," Ramsey says. But at the very least, it's a sign that you should be more cautious.

1. A wonky transport indicator flashes red

According to Dow Theory, which is a branch of technical analysis, when upward moves in the Dow Jones Industrial Average are not confirmed by the Dow Jones Transportation Average DJT, +0.87% , it's a red flag for the market. That's not the case now. True, the Dow Jones Transportation Average has been weak. But it hasn't been weak enough long enough to trigger the classic Dow transports signal.

However, a little-known Transports-related indicator is flashing red, Ramsey notes. On August 1, the relative strength of the Dow Jones Transportation Average hit a one-year low. But the Dow Industrials closed at a one-year high. This combo is pretty uncommon. But when it happens, it's not good for bulls. This signal flashed on the eve of the bear markets of 1973-74, 1987, 1990, 2000-02, and 2007-09, and just before the 2015-2016 correction. This signal has also misfired several times. But it's still worth nothing that "a mild setback in the transports has rendered a signal that’s often spelled trouble," Ramsey says.

The bottom line: None of this is a prediction that the market will necessarily sell off sharply over the next several days. But conditions have been ripe for more volatility — and still are. So that's what we can expect over the next few months.

Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter “Brush Up on Stocks.”