The market is smarting from an acid-reflux burn in the middle of a "digestion year" for stocks.

From a wide-angle view, the 2% drop in the Standard & Poor’s 500 index Thursday doesn’t call for any elaborate forensic inquiry. Even though there have been only four such one-day declines since the start of 2012, a typical market year features a few of them. Still, it’s fair to observe this is a sort of “catch-down” move, featuring the large-stock indexes belatedly succumbing to the downward pull of ragged action in high-yield debt and small-cap stocks.

Michael Hartnett, Merrill Lynch’s chief investment strategist, suggested Wednesday that some late-summer agita might arise, citing the “fatigue of ‘leaders’” as a heavy weight on the broad market. Specifically, he notes the weakness in small stocks, high-yield debt and bank shares as three stalwart sectors of strength that were under ample pressure.

High-yield debt alarms

Junk debt in particular has been raising alarms in recent weeks, with selling dragging yields higher relative to Treasuries. The strength in credit markets has been the lodestar for equity markets for years now, and the Standard & Poor’s 500 index had run ahead to new highs without the explicit support of credit-market strength.

Concerns about illiquidity in the corporate-bond market in a shrunken post-crisis Wall Street trading arena are also hovering nearby. I wrote about potential weaknesses in the “plumbing” of the bond market more than a year ago, and since then this has become a common talking point among market participants.

The litany of excuses for the selloff extends to a sharper-than-expected rise in the employment cost index that further emboldened the bond market to raise the probability that the Federal Reserve will be pressed to lift short-term rates before Chair Janet Yellen currently intends.

This concern was calmed somewhat by Friday's not-too-hot employment report for July, showing stalled wage growth, slightly fewer net new jobs than expected and a nudge higher in the unemployment rate to 6.2%, driven by a small rise in the number of people looking for work. (Index futures pared steep losses after the report, and stocks are flat in early Friday trade.)

If the labor market is indeed tighter than Yellen has characterized it and the two-year Treasury note continues rising in provocation of quicker Fed reaction, it disturbs the “low growth/high liquidity” backdrop investors have taken such comfort in the past couple of years.

[Is the market also extrapolating higher wage costs into pressure on corporate profit margins long-bolstered by cheap labor? Who knows, maybe – just throw it on the pile of notional catalysts for investor skittishness.]

It’s still premature to say the Fed will be provoked to accelerate its rate “normalization” plan, but the markets are bracing in advance, as the two-year Treasury note yield (the most sensitive to changes in Fed expectations) has climbed to 0.55% from 0.35% in May.

Higher rates for “the right reasons” of stronger growth should in theory be just fine with investors, and historically that has been the case early in tightening cycles in which long-term and short-term rates begin rising. But for now it upends the “heads-I-win-tails-you-lose” element of equity investors enjoying both a recovering economy and highly stimulative Fed. This is especially relevant given that low-growth “bond-like” dividend stocks have done more than their share to hold up the indexes this year, including those in the crowded “3% yield club.” This group has slumped far more than the broad market in the past month.

The same perverse motivations that led the stock market to shrug off a 2.9% decline in first-quarter GDP has led it to balk in the face of generally better growth numbers.

Meantime, persistent sluggish growth and deflationary signals in Europe are spurring some nervousness in the debt markets there. This at least raises the prospect of one huge economy in the U.S. – the one with the typically more aggressive central bank – requiring tighter money, and another in Europe stagnating and "asking" for easier money that the European Central Bank seems less eager to offer.  

The churning beneath the mostly sideways action in the blue-chip indexes is quite consistent with the digestion year analogy aired here in April, much like we saw in 2005 – a flattish period with only rare bouts of volatility.

As in 2005, this year was preceded by an all-inclusive “melt-up” in stocks that reflected a better economy and lower-risk environment but also fattened stock valuations well beyond “cheap” status. Corporate profit margins were already high, and in both years the Fed was transitioning monetary policy – in a well-telegraphed way – from extreme generosity to something closer to “normal.”

Familiar patterns

The patterns of this year haven’t followed 2005 in lockstep, but they’re close enough. The Dow Jones Industrial Average made no headway in the fist seven months of 2005, slipping 1.5% by July 31; this year the Dow has a fractional loss through the same date.

The bright side of this pullback in the S&P 500 having been foreshadowed by weeks of downside action in small-cap indexes and the “average” stock is that it’s already far along rather than just getting started. Now that the big indexes have obliged with an attention-grabbing one-day slide and stoked a welcome bout of investor anxiety, the watch is on for the market to get oversold enough and for trader sentiment to get negative enough to imply, once again, this might be a buyable dip.

Chris Verrone, technical analyst at Strategas Research, says: "For context, the correction this January lasted 14 trading days and resulted in a -6.1% decline from peak to trough (the current pullback is just 5 days old and only -3.0% off the highs).  We’re still ultimately in the 'buy the dip' camp, but it may take lower prices first."

Corporate profits have remained OK, on balance, arriving better than forecast but with plenty of clunkers and nasty reactions, reflecting the very mature state of the earnings cycle.

Lower stock prices with aggregate earnings still rising make stocks less expensive – not more risky – and suggest (timidly) this is more like the shakeouts of April and in summer 2013 than the start of an enduringly nasty bear phase. This could be a needed “attitude adjustment” rather than recognition of a suddenly worsening fundamental picture. The mergers-and-acquisitions and activist-investing key party shows no signs of winding down, which are net positives for stocks in the intermediate term.

Keep an eye on the junk-bond market, the Russell 2000 small-cap index and banks – particularly smaller banks as measured by the First Trust Nasdaq ABA Community Bank ETF (QABA) – for signs that the selling is drying up (or not). And remember, digestion isn't always comfortable.