On Thursday, for the second time so far this month, the stock market suffered an epic “outside reversal.” This is where initial morning gains, above the previous day’s highs, give way to an avalanche of selling that pushes the close below recent lows.
For chart watchers, this is a serious sign of weakness.
And to have a group of these patterns clustered together suggests more trouble lies ahead.
Yet again, the weakness was concentrated in the popular big technology and biotech stocks that were leaders in 2013, but have since succumbed to persistent underperformance.
So what went wrong? Simply put: Despite everything, the global economy is slowing.
The Nasdaq Composite was the hardest-hit of the major indices, dropping 3.1% for its worst one-day loss since November 2011. Biotech stocks (IBB) lost 5.6% in the largest one-day loss since August 2011. And futures contracts in Japan’s Nikkei Average, the epicenter of the recent market pullback, hit the 14,000 level and are now down more than 14% from its recent highs to six months lows.
Just 24 hours ago, today’s results seemed about as likely as aliens landing in Central Park. The market launched higher as the Federal Reserve seemed to be following the script that has served it so well over the last five years: Promise more cheap money, and watch stocks fly.
The release of the Fed’s March meeting minutes were interpreted by the market to represent some backpedaling from a harsher-than-expected March policy announcement and post-meeting press conference on March 19. But the good feelings have since faded.
The tech-heavy Nasdaq is now down 7.3% from its pre-Fed highs in early March.
The problems started to materialize deep within the bowels of the market yesterday: The yen carry trade, which I’ve been hammering on about recently, started to melt as the U.S. dollar weakened in response to the Fed news.
The proxy for this trade, the ProShares UltraShort Yen (YCS), threatens to fall out of a four-month long support level — a development that would cause the stock market’s losses to accelerate.
Japan’s stock market peaked in late December, in unison with the yen carry trade, and has been drifting lower ever since as hopes are shattered that a weaker currency would end Japan’s multidecade malaise. Hedge fund types have piled into this trade, using a weaker yen to fund speculations in stocks and bonds.
And this gets to the core of why stocks around the world are selling off now: Despite the efforts of the central banks, and the trillions in cheap money that has been pumped into the system, the global economy is hitting a wall and threatening corporate profits.
The reversal of the yen carry trade is acting as an accelerant in this dynamic — flushing stocks lower with intensity as traders scramble to close their multi-leg positions (buy yen, sell dollars, sell stocks).
Here at home, economic data has been warning of trouble for months as the Citigroup Economic Surprise Index has fallen to a level not seen since the middle of 2012. This index drops when the economic data consistently comes in below analyst estimates. This not only measures what’s happening in the economy, but it measures where market expectations are.
When expectations are high but the data is weak, which is the situation now, the stock market tends to underperform.
Yet it was weak economic data out of Japan and China overnight that really catalyzed Thursday’s losses. Japanese machine orders dropped nearly 9% in February over January. And in a possible sign of deepening trouble in China, both import and export volumes tumbled in March.
So there you have it. An overconfident, overleveraged market with too much faith in the power of cheap money is now suffering its worst selloff in years. Significant technical support has already been lost. And with both the economic data and corporate earnings likely to keep disappointing in the near-term, the evidence suggests there is more downside to come.
I continue to recommend investors raise cash and move into defensive assets including Treasury bonds and precious metals. The SPDR Gold Shares (GLD) exchange-traded fund has moved back above its 50-day moving average for the first time since January. I added the leveraged ProShares UltraGold (UGL) to my Edge Letter Sample Portfolio earlier this week.
And to give you an example of how quickly profits can accumulate in an environment like this, my put option recommendations in big tech stocks have been on fire: My April $65 puts against Facebook (FB) are up 215%, my April 350 puts against Amazon (AMZN) are up 232%, and my April 36 puts against Yahoo (YHOO) are up 114%.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he had recommended the options positions mentioned above to his clients.