By Rodrigo Campos
NEW YORK (Reuters) - Cracks are showing in what has been a virtually non-stop U.S. equity rally after a rapid escalation of tension between North Korea and the United States this week.
Market analysts expect that the pullback in stocks due to the increasingly aggressive tone in exchanges between Washington and Pyongyang will continue, although investors hope that the selling will not escalate to a correction - a decline of 10 percent or more.
The benchmark S&P 500 index tumbled more than 1 percent on Thursday, only the third time this year it has fallen that much, while the Nasdaq shed more than 2 percent.
"Markets are looking for any reason at all for a reset. That reset is being triggered by North Korea geopolitical concern and stretched valuations," said Peter Kenny, senior market strategist at Global Markets Advisory Group in New York. "I do think we could see markets pull back between 1 and 5 percent."
The S&P is trading near its most expensive valuation level since 2004, as measured by the price-to-12-month forward earnings ratio.
U.S. stocks have risen week after week this year - with the S&P up more than 9 percent - in extremely low volatility, as strong corporate earnings and an improving global economy offset disappointment that U.S. President Donald Trump's promises to lower corporate taxes and implement a massive infrastructure spending have so far failed to see the light of day.
Until this week, the equity market had managed to shake off negative news, including previous saber-rattling over North Korea and failures in Washington to pass high-profile bills, such as repealing and replacing Obamacare.
But although U.S. equities on Wednesday managed to close only slightly down even after Trump's warning that "fire and fury" would rain on North Korea, on Thursday the chickens came home to roost on Wall Street.
More than 430 stocks from all U.S. exchanges hit their lowest levels in 52 weeks or more on Thursday, the most for any session since mid-November right after Trump was elected. The average for new 52-week lows this year is about 230 per day.
"The easy money has already been made," said Joel Kulina, senior vice president of institutional cash equities at Wedbush Securities in New York. "I’m looking selectively at the pullbacks, but my gut is that we could be in for a bumpy ride for the next couple of months or so."
Many market participants have been calling for a significant decline on the S&P 500.
“A pullback is good so the market doesn’t get unidirectional. This is a normal fluctuation, it just seems so odd because we have hardly had any volatility,” said Jim Paulsen, chief investment strategist at The Leuthold Group in Minneapolis.
If the decline continues, Paulsen said, it will be "a good buying opportunity. I’d look into energy, materials, industrials, tech and financials. I think before the end of the year the market goes to new highs and (Treasury) yields go higher."
The benchmark U.S. yield on Thursday was just above 2.2 percent, at its lowest level since late June, as investors bought up Treasuries, a classic safe harbor. Yields on bonds move inversely to their price.
And in a textbook-type cross-asset move toward safety in times of trouble, the Japanese yen hit an eight-week high against the U.S. dollar while spot gold also reached a two-month high.
The CBOE Volatility Index, better known as the VIX and the most widely followed barometer of expected near-term stock market volatility, rose the most in about 12 weeks.The index ended up 4.93 points at 16.04, the highest level since Nov. 8, when Trump was elected president.
In an inversion of the curve, the spot VIX rose above VIX futures, meaning traders are paying more for protection against a sudden sharp drop on the S&P than for protection in the future.
"We're not very oversold yet so the market still has more downside left to it," said Robert Pavlik, chief market strategist at Boston Private Wealth in New York.
"We're still close to the all-time high so that makes people a little nervous too, so they might say now might be the time to take a little bit of money off the table.
(Reporting by Rodrigo Campos, Caroline Valetkevitch, Saqib Iqbal Ahmed, Sinead Carew, Kimberly Chin and Lewis Krauskopf in New York and Noel Randewich in San Francisco; Editing by Megan Davies and Leslie Adler)