Suddenly, investors who were lulled into a warm, comforting sense of complacency in December are being hit in the face with the arctic chill of reality. No, not all is well. No, cheap money cannot solve all our problems. And no, the ongoing tapering of the Federal Reserve’s QE3 bond purchase stimulus is not as benign as the bulls would have you believe.
Stocks are falling hard today, with the Dow Jones Industrial Average down 3.6% from its ridiculous New Year’s Eve melt-up, falling through its 50-day moving average and threatening to close below the psychologically important 16,000 level.
This is the most significant downtrend initiation since September, when the market started worrying about the October debt ceiling deadline — a deadline that was pushed back to February, unleashing a powerful market rebound.
Unfortunately, the current pullback has many more catalysts, which means it won’t be so easily reversed.
Here are five reasons you should be worried, and be prepared for a more protracted decline.
Market Fear #1: Emerging Trouble in Emerging Markets
Click to Enlarge For months, stocks in emerging markets have been badly underperforming seemingly invulnerable U.S. equities. After peaking in mid-October, the iShares MSCI Emerging Markets ETF (EEM) has been on a steady downslope and is now falling into what looks like a sinkhole.
They’ve got problems.
Especially China, which is watching in horror as its export-driven economic miracle becomes a nightmare of excess credit, overcapacity, asset bubbles, vulnerable banks, a shrinking workforce and higher wages. Chinese financial institutions repeated the sins of U.S. banks during the housing bubble, repacking shoddy commercial loans into off-balance sheet vehicles and dumping them on investors who believed they carried an implicit guarantee by the issuing bank. We could see a default on one of these vehicles by the end of the month.
Adding to the pressure was a weaker-than-expected manufacturing activity report out of China on Thursday.
But it’s not just China. The Fed’s tapering actions are causing capital outflows and currency weakness in many emerging markets (on expectations of a stronger dollar), collapsing markets and exchange rates from India to Thailand and Argentina.
Market Fear #2: The Unwind of the Yen Carry Trade
Click to Enlarge One of the main catalysts for the severe selling pressure is an unwinding of the yen carry trade — the selling of the Japanese yen short by hedge fund types, who then used the proceeds to plunge into U.S. and European assets. That helped fuel the U.S. market melt-up and has pushed down peripheral eurozone bond yields, effectively ending all of the concerns over the health of Greece, Spain and Italy.
As long as the yen was falling, and as Tokyo actively weakened its currency via cheap-money stimulus in a last-ditch effort to reinvigorate Japan’s economy via increased export competitiveness, everything was fine. In Japan, the drop in the yen was encouraged by the assumption that the Bank of Japan was set to unveil an expansion of its quantitative easing program, perhaps as soon as this spring.
But now, as the yen surges, things are not fine. Traders are scrambling to close these positions, dumping everything en masse. The yen looks less desirable as a one-way bet as current efforts have attracted the ire of trading partners, such as South Korea, and have failed to boost wages as Tokyo desired. Instead, food and fuel prices are rising, pinching consumer spending power.
The ultimate end game for Japan, which is heavily indebted and vulnerable to any increase in government borrowing costs, casts a long shadow over the situation should any reduction in the pace of quantitative easing cause turmoil in the Japanese government bond market.
Just look at the way the proxy for the yen carry trade, the ProShares UltraShort Yen (YCS), is falling out of the sky.
Market Fear #3: Corporate Earnings
Click to Enlarge Heading into the Q4 earnings season, there was a big disconnect between overly optimistic analysts and investors and corporate executives desperate to roll back expectations. The negative-to-positive pre-announcement ratio of S&P 500 companies hit a record high, yet expectations wouldn’t budge.
As Q4 results have rolled out, major component after major component has been hit over the head with selling after disappointing results or gumming up earnings with non-GAAP “one-time” items to hide the truth: that historic levels of corporate profitability, fueled by cost cutting and share buybacks funded by cheap debt, is coming to an end.
This dose of reality is hitting bank stocks especially hard, since they’ve been the market leaders for so long thanks to an improvement in the housing market and the steady release of loan loss reserves straight to the bottom line of their income statements.
Now that higher interest rates are pinching the housing market, sucking the wind out of the bond market, and making loan loss reserve drawdowns look more and more ridiculous, shares are tumbling. Look at JPMorgan (JPM), which has entered its most severe downtrend since August.
Market Fear #4: Investor Complacency
Click to Enlarge Heading into this pullback, the level of mindless bullishness had reached historic extremes.
Investors Intelligence had the ratio of bulls-to-bears at levels not seen since 1987. Retail investors started pulling money out of bonds and putting it into stocks for the first time since the financial crisis — a classic warning sign that the “dumb money” was getting in. And cash on the sidelines, whether in money market mutual fund accounts or in cash reserves held by mutual fund companies, dwindled to nil.
All the while, market breadth kept narrowing as the foaming-at-the-mouth bulls focused on fewer and fewer stocks to keep the major averages aloft — such as biotech stocks (above) and transportation stocks, which went vertical over the last few weeks. The percentage of NYSE stocks above their 50-day moving averages peaked at 85% in October and has been sliding ever since. It spent most of January near 70%.
It’ll take some severe price damage to reset the situation, and that will put fear back into the hearts of investors.
Market Fear #5: Trouble out of Washington
Click to Enlarge Two big catalysts are looming out of the capital: Another $10 billion taper of QE3 by the Federal Reserve at its policy meeting next week (as the unemployment rate keeps collapsing) and the return of the debt ceiling fight in February (which will start with President Obama’s State of the Union address next week).
The debt ceiling fight isn’t really being talked about yet, but it soon will. Expect partisan rancor to reach new heights as Republicans and Democrats play hardball heading into the 2014 midterm elections.
Additional tapering will put further pressure on emerging markets equities and currencies, but the Fed has little choice but to continue the taper as the unemployment rate falls through their targets (driven mainly by people leaving the workforce), as inflation is poised for a bounce on higher food prices (driven by the drought in California) and as wages tick higher (as businesses have a harder time finding workers).
For now, I continue to recommend investors seek safe havens, such as Treasury bonds (shown above). The leveraged Direxion 3x Treasury Bond Bull (TMF) is up 8.4% since I added it to my Edge Letter Sample Portfolio on Jan. 10. My short in Best Buy (BBY) is up nearly 40%. Overall, the Edge Portfolio is up 15.1% this month vs. a -2.2% loss for the S&P 500.
As of this writing, Anthony had recommended TMF long and BBY short to his clients.