Dreams die hard. And we know now that the U.S. stock market had been living a dream. Investors had convinced themselves that a strong U.S. economy, juiced by tax cuts and other fiscal stimulus, could offset higher interest rates, the impact of President Donald Trump’s tariffs, and slowing growth elsewhere around the world.

That had allowed the S&P 500 to return 11% during the first nine months of 2018, even as the remainder of the world’s stocks fell more than 5%.

All of that came crashing down this past week. The S&P 500 slumped 4.1% to 2767.13, while the Dow Jones Industrial Average tumbled 1107.06 points or 4.2%, to 25,339.99, and the Nasdaq Composite sank 3.7% to 7496.89. It took a confluence of events to finally wake investors up.

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The alarms rang almost in unison. The yield on the 10-year Treasury note hit a seven-year high after Federal Reserve Chairman Jerome Powell said the federal-funds rate target could still go higher. Vice President Mike Pence gave a speech about China that made investors realize that tensions between the two nations might not be easing soon. And, allegations of China placing spy chips in tech products caused technology stocks to take it on the chin.

That might have been fine if the damage had been limited to tech, but fears about growth were added to the mix. On Tuesday, the International Monetary Fund cut its forecast for economic growth. Two industrial companies few usually pay attention to—
PPG Industries

(ticker: PPG), which makes paints and coatings, and
Fastenal

(FAST), an industrial distributor—highlighted a tariff-induced profit-margin squeeze. It was proof, at last, that the U.S. wouldn’t remain immune to the damages caused by tariffs.

“With margin pressures creeping in and the Fed raising interest rates, it causes bouts of volatility along the way,” says Jason Pride, chief investment officer of Glenmede’s private wealth division.

Even that might not have caused the Dow Jones Industrial Average to shed nearly 1,400 points in just two days if investors hadn’t bet massive amounts of money on the dream.

One example highlighted by strategists at RBC Capital Markets: Futures contracts used by asset managers to bet on the Dow going higher had surged to levels last seen at January’s peak. The market’s drop was like yelling fire in a crowded theater, as these positions had to be unwound quickly.

That doesn’t mean this is the end of the bull market. More often than not, a market top is a process, as investors gradually price in a recession. Usually there are opportunities to exit along the way. That was the case even during the prior bear market, when investors could have waited for a yield-curve inversion to exit and still avoid the real pain inflicted by the financial crisis. Such an inversion—when short-term rates rise above longer-term ones—is as solid a recession predictor as there is.

The biggest worry is that the past eight months or so have been that topping process, and that the market has already peaked. Smarter folks than us think so. But the yield curve still hasn’t inverted—in fact, it had been steepening until the sudden selloff prompted investors to run for the safety of the 10-year Treasury.

Other leading indicators, including jobless claims and credit spreads, have also held up. “I don’t see this all leading to recession,” says Ed Yardeni, president of Yardeni Research. “And without a recession, I don’t think we get a bear market.”

When stocks bounced on Friday, it delayed a true washout, but there are likely to be more scares, more drops, more pain, before stocks start heading higher again. “The process can look like a shampoo commercial,” says Christopher Harvey, head of equity and quant strategy at Wells Fargo Securities. “Lather (selloff), rinse (rebalance), and repeat.”

But at least the dream won’t soon become a nightmare. 

Write to Ben Levisohn at Ben.Levisohn@barrons.com

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