Why stocks could drop again

Stocks are back, baby!

After watching in horror as the Dow Jones industrial average dropped more than 1,000 points at the open on Monday, investors are rejoicing in the wake of what's been the best two-day rally in years. The Dow is already up nearly 1,300 points from its low amid a rip-roaring rebound in commodity prices and tech-stock sweethearts like Apple (AAPL).

But the evidence suggests that instead of diving back in, investors should remain cautious.

For one, the S&P 500 is on the verge of its first "Death Cross" -- a move by the 50-day moving average below the 200-day moving average -- since 2011. This is a sign of a clear deterioration in the market's medium-term trend strength. The Dow suffered a Death Cross earlier this month.

Volatility expectations, as measured by the CBOE Volatility Index (VIX), suggest the selloff isn't over as the "fear gauge" remains elevated.

Societe Generale analyst Albert Edwards also notes that there is a good chance this is all happening in the context of a new bear market based on the findings of a model that looks at periods when stock price momentum and quality become highly correlated. When that happens -- when investors are aggressively bidding up a narrowing list of good stocks (based on balance sheet measures) while ignoring the rest -- it typically marks periods of broad market underperformance.

He also flags a precipitous decline in inflation expectations in the bond market, which have fallen to levels not seen since the recession. Translation: Bond traders believe something is very wrong with the global economy.

Finally, market history offers good reason to be cautious. Jason Goepfert at SentimenTrader notes that when the S&P 500 posts a reversal like we've just seen -- defined as the best one-day gain in more than three years shortly after the worst one-day loss in three years -- returns tended to be underwhelming in the weeks that followed.

On average, stocks were down nearly 6 percent one month later. The last such occurrence was in September 2008 on the eve of the financial crisis, in which the index lost 25 percent in the month that followed.

While the last two days may provide comfort to investors, it's important to remember this: Big rallies tend to come in the context of larger downtrends. Indeed, the last time the Dow rallied more than 6 percent in two days was in the maw of the 2008 meltdown.

It's also worth recalling that a big reason why stocks fell in the first place was the release last week of the minutes of the Federal Reserve's July meeting. Investors are nervous about a possible rate hike next month at the Fed's September 17-18 policy meeting, which would be the first policy tightening seen since 2006.

The Fed has moved to calm those fears, proving once again that equity prices are a key concern (despite pleas policy is set based on economic data alone).

On Wednesday, New York Federal Reserve Bank President William Dudley lowered expectations for a September interest rate hike, noting that case for tightening was "less compelling" given the recent financial market turmoil. This flies in the face of comments last Friday from St. Louis Fed President James Bullard that the Fed does not react directly to equity markets.

The economic fundamentals make summarily dismissing a September rate hike difficult. On Thursday, second quarter GDP growth was revised upward to 3.7 percent, up from 2.3 percent and the best result since the third quarter of 2014.

All eyes will now turn to the upcoming release of the August payroll report on September 4. If job growth remains strong, increasing the odds of a liftoff in interest rates, investors could very well get spooked again.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.