This September sag in stocks looks a lot like the midsummer swoon

Go get checked out for a recurring ailment and the doctor is likely to ask if it feels similar to the last flare-up and how much it hurts in comparison. The symptoms the stock market is suffering from this week strongly resemble those from the July-to-August decline, though the pain inflicted is not quite as bad (yet).

The current pullback is still a couple of percent shy of the ultimate midsummer decline, which itself was a harrowing but relatively mild setback for a market that hasn’t been hit by as much as a 10% drop in three years.

As in July, the headline equity indexes – Standard & Poor’s 500 and Dow Jones Industrial Average – are undergoing a “catch-down” move toward small-cap and high-yield credit markets that have been under pressure for weeks.

Even as the S&P 500 made a new intraday high of 2014 on Friday (prompting some reflection on the bull market’s progress here), the number of stocks propelling the advance was rather thin. And the small-cap Russell 2000 – a pronounced laggard all year – was not invited to the new-high celebration.  

Back in late July, the Russell 2000 had peaked on July 3 and had been sagging for three weeks when the S&P 500 finally topped out for a while on July 24. High-yield debt spreads – the extra yield above Treasuries – had also been widening, a sign of creeping risk aversion that often hits small stocks most directly.

The Russell back then ultimately fell 7.7%, bottoming Aug. 1 several days before the big-cap S&P 500 hit a low on Aug. 7, down 3.9% from its high. As the market was selling off hard Thursday afternoon, the Russell’s drop from its recent Sept. 2 high was 5.7%. The S&P 500, which again didn’t start to falter until a couple weeks of small-cap weakness, was off a bit more than 2% from the Friday peak.

As noted in the attached video from my CNBC appearance Thursday morning, high-yield debt is an important tell, and small-cap stocks are how credit anxiety is transmitted into the equity market. Money has been leaking from this sector as investors collectively begin to anticipate a world of marginally less easy money and perhaps higher rates.

Strategist Michael Hartnett of Bank of America Merrill Lynch says, “We believe the poor performance of commodities, emerging markets, high-yield bonds and small caps is a harbinger of lower liquidity, the end of excess returns and the end of excessively low volatility.”

The extremely strong run higher in the dollar against the yen and euro is both a result of this anticipation of lower liquidity and a reflection of expectations that the Federal Reserve is gingerly approaching an interest-rate boost. This is even as other developed economies remain weak enough to suggest further central-bank stimulus is called for in Europe and perhaps China.

This uneven path of regional growth means decidedly different expectations of interest rates and currencies taking shape among global investors.

As Hartnett puts it: “The 2015 risk that 'escape velocity' in the US collides with ‘reverse velocity’ in the euro zone (via further misery in real estate, bank lending and the small business sector) means a short euro position versus the U.S. dollar should continue to prove profitable.”

Sharp divergences cause rapid shifts in global capital flows, and the immediate worry is that some concentrated, crowded trades will get knocked loose in an unexpected way by such quick moves in currencies and asset markets.

Of course, expectations and explanations are flexible and prone to quick revision. The strong dollar could easily generate more talk that it will give the Fed cover to go even slower in removing stimulus, which markets would likely cheer for a while. When stocks fall without much erosion in profit expectations, they get cheaper and less risky – something that might become clear as earnings season approaches.

It's worth noting, too, that we are in a brief stretch of the calendar when markets tend to have some trouble, to be followed by the usually strong fourth quarter.

None of this means a springy recovery, like the one that followed the summer selloff, is necessarily near. But there’s enough that looks familiar about this bout of weakness that, as the market continues to get oversold, investors shouldn’t dismiss the abiding presence of “upside risk.”