Stocks are tumbling again on Thursday, with the S&P 500 and Dow Jones Industrial Average testing their 50-day moving averages while the Russell 2000 small-cap index sets new correction lows after trying, and failing, to stay above its 200-day moving average.
The intense bout of selling — coming just days after the large-cap indices set new all-time highs — is catching many investors by surprise.
At least, those who have only been paying attention to the Dow or the S&P 500.
Because if you were watching the drop in small caps or U.S. Treasury yields, you would know the situation was weaker than it appeared.
Moreover, the evidence suggests that, at least for small caps, the correction is only about halfway done.
Click to Enlarge Let’s look at the two main catalysts for the pullback we’ve seen over the last two days.
The first is the rising threat of inflation — something the economy hasn’t contended with since 2012. Both consumer and producer price inflation has taken a marked turn higher, led by food and shelter but altogether rather broad-based. And that suggests that this new inflation is going to be powerful and persistent.
Not only does that jeopardize the flow of stimulus out of the Federal Reserve that has sustained this market, but it pinches household pocketbooks as well. Indeed, Walmart (WMT) reported weaker-than-expected quarterly results Thursday morning with same-store sales traffic declining and the impact of winter weather not enough to justify the miss to the bottom line.
This adds credence to the idea that the U.S. consumer is hurting given Tuesday’s disappointing retail sales report. Shoppers are being beleaguered by higher inflation on food and shelter amid ho-hum earnings growth.
Click to Enlarge The other main catalyst was a big selloff in the eurozone bond market, the worst in 15 months, on a weak GDP report and a drop in forward inflation expectations.
Also contributing was chatter that Greece was considering retroactively taxing certain bond sales this year, which shattered sentiment despite Athens fervent denials such an idea was being considered.
This is having such a large impact on the U.S. stock market because of the popularity of the so-called yen carry trade, whereby hedge funds and other institutional traders would sell the Japanese yen short and use the proceeds to buy stocks and bonds denominated in euros or dollars. This is why eurozone bond prices have been rising so powerfully since late 2012, pushing down eurozone borrowing costs and quelling the region’s debt crisis.
The Japanese yen is poised for a massive upside breakout from the tight consolidation range that has held it since January as it becomes increasingly clear Tokyo’s currency-devaluation-as-salvation strategy isn’t panning out. Also, weak European GDP and inflation numbers will encourage the European Central Bank to unleash new stimulus measures that will push down the euro.
A stronger yen and a weaker euro will encourage selling in all types of assets, including U.S. stocks and eurozone bonds as yen carry trades are closed.
Last But Not Least
Let’s not forget that U.S. small-cap stocks have been suffering from some good, old-fashioned overvaluation as well. According to Credit Suisse, the price-to-sales multiple on the Russell 2000 rose to just below its all-time high set in the late 1990s earlier this month. They estimate the correction in small cap stocks has another 8% of downside progress yet to go.
The big question is: How long can the large cap stocks trade near record highs, resisting the negative impact of the reversal of the yen carry trade and the persistent weakness of small caps?
Not likely for long, which is why I’ve been recommending clients move into defensive assets including the leveraged Direxion 3x Treasury Bond Bull (TMF), which I just closed for a 22% profit in my Edge Letter Sample Portfolio. My latest addition is the VelocityShares 2x VIX (TVIX), a leveraged play on the CBOE Volatility Index or “fear gauge” that rises when stocks are falling.
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 TVIX to his clients.