There is much more to the first-quarter drop in the S&P 500 Index than its modest 1.22% decline suggests. Everything from changing narratives in technology stocks to higher asset price correlations reveals a watershed moment for a bull market that has been underway since 2009. That was on display Monday, with the benchmark posting its worst April start since 1929.

Below is a list of what the first quarter taught us about current market dynamics, and how they may inform investor psychology going forward.

1. Too many investors are still overweight technology shares. Large-capitalization U.S. tech stocks were largely a one-way trade from 2010 through 2017, consistently outperforming with low overall market volatility. As a result, a lot of “lazy long” money flowed into the sector. The price action in large-cap tech shares the last few weeks underscores how many weak hands still over-own the sector. Tech insiders have been warning about data privacy and insular managements for several years, yet Facebook’s recent challenges clipped the stock price by almost 20% and hurt overall group performance.

That’s clear evidence of the market’s negative reaction to price momentum rather than the specter of new fundamentals coming to the fore. This means tech stocks will remain volatile amid an uncertain regulatory environment and shifting business models. It should not be as bad as 2000-2002, if only because the group now features real profitability and dominant market share in important segments such as online advertising.

2. Big Tech is not a lean, artificial intelligence-powered black box of endless profits, but rather a messy jumble of hardware, software and lots of much-needed human intervention. Self-driving cars caused a pedestrian fatality. Facebook, Google and others backtracked on their basic investment thesis of offering advertisers an entirely automated system to gather, hold and monetize social attention. Tesla remained woefully short of basic manufacturing skills.

Software may still eat the world, but it is going to have some very bad indigestion along the way. That will temporarily, at least ding both risk premiums and terminal values as investors struggle to discount news flow into their valuation frameworks.

3. Volatility may be an absolute measure, but humans perceive it in relative terms. The sleepwalking equity market of 2017 gave way to one with chronic night terrors last quarter. That shift, combined with lofty valuations, has sparked concern that domestic stocks are setting up for a 1987-style crash. The truth is that the first quarter was a normal one for volatility if you exclude recent history from 2010 through 2017. The CBOE Volatility Index, or VIX, closed March at 19.97, right at its long-run average.

Volatility returning to its long-run historical form is healthy, but over the next 90 days it will feel tumultuous.

4. What Washington gives, it can also take away. The promise of tax reform was last year’s central investment theme. Investors in the first quarter shifted their focus to trade policy. One was good for equity prices; the other was not.

Markets mistook President Donald Trump’s numerous 2017 tweets about record high stock prices as a signal of unwavering support. They weren’t. The president’s agenda has many components, only some of which are friendly to capital markets.

5. Equity sector correlations increase at the first sign of market stress and stay there. The most underappreciated market dynamic of 2017 was the drop in individual equity sector price correlations to the overall market. From an average 80% positive correlation, they dropped to 50% right after Election Day 2016 and remained low all last year. With last quarter’s spike in volatility, they have returned to their pre-election levels.

Expect correlations to remain elevated while investors piece through the other themes mentioned in this commentary. This will unavoidably feed higher levels of overall market volatility given the mathematical relationship between correlations and daily market price churn.

6. Fixed-income markets matter again. This trend started with the early February drop in stocks that coincided with higher long-term bond yields. It picked up steam as the quarter progressed, with unusual increases in the London interbank offered rate and commercial paper rates, among other measures. None of this is comfortable for equity investors, who much prefer looking at financial statements and speaking to company managements.

Two areas of the fixed-income markets will have an outsize influence on equity valuations this quarter. The first is federal funds futures, which will give a sense of whether investors expect the Federal Reserve to raise interest rates four or more times in 2018. That market currently indicates just a 30% chance rates will rise above 2.25% this year. If the odds exceed 50%, equities will likely falter. The second is the spread between two- and 10-year Treasury note yields. At a slim 47 basis points, the gap is the easiest way to assess if debt markets believe the Fed is stumbling into a policy mistake. As this spread approaches zero, expect equity markets to share that concern.

In summary, the first quarter of 2018 was an important period of transition away from the narratives that defined asset prices for most the decade. How quickly investors adapt to new paradigms will define both their individual performance and where asset prices settle over the remainder of the year.

— For more Bloomberg View columns, visit http://www.bloomberg.com/view.


Nicholas Colas is the co-founder of DataTrek Research. He is the former chief market strategist at Convergex Group LLC.

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