For the first time in the history of the history of the International Monetary Fund, an advanced county is set to default on its obligations. In a couple of hours, Greece will do this when it fails to pay a bundled $1.8 billion repayment to the fund.
Bailout talks with its European creditors broke down Tuesday, setting the stage for an end to its current assistance arrangement, a possible withdrawal of liquidity support to its financial system from the European Central Bank, and rising tensions going into the planned July 5 popular referendum on staying within the eurozone.
While stocks managed a feeble rebound on Tuesday, the bulls couldn’t stop the market from finishing in the red for June and the second quarter. Transportation stocks fared worse, posting the first back-to-back quarterly decline since the fallout from the Lehman Brothers crisis.
In the end, the Dow Jones Industrial Average gained 0.1%, the S&P 500 gained 0.3%, the Nasdaq Composite gained 0.6%, and the Russell 2000 gained 0.6%.
Sentiment was helped by a 5.5% gain in Chinese equities — after being down 5.1% early in their session — and headlines that Greece officials are starting to submit new bailout proposals to its creditors.
But don’t be fooled: Athens has invested way too much political capital in the upcoming referendum to cancel it now, as the optimists are hoping. Instead, this looks like a way to build up animosity towards its creditors as the vote approaches — a variation of the “blame game” as Greece looks like it’s making an honest effort.
On the important things, there has been no movement. Europe isn’t considering debt relief for Greece for fear other indebted nations with rising populist political movements — such as Italy and Spain — will be emboldened to ask for a similar deal. And Greece is sticking to its guns on protecting pensions. And as a result, the country will certainly miss its $1.8 billion debt repayment deadline to the International Monetary Fund tonight.
Once that happens, things are likely to quicken. The European Union will declare that Greece’s current bailout agreement, which was extended back in February, has lapsed. That could result in the European Central Bank rolling back its liquidity support of the Greek financial system. Also, the EU could declare Greece in default of its non-IMF bailout funds.
With more scary headlines coming, Wednesday should see a resumption of Monday’s selloff.
The optimists are doing their best to dismiss the risk of the Greek financial crisis. They point out the economy is smaller than Louisiana’s. They point out that unlike in 2011 and 2012, the European Union has built up defenses against financial contagion including the European Central Bank’s ongoing bond buying stimulus.
In comments on Tuesday, President Obama said the situation in Greece “is not something that we believe will have a major shock to the system.” This comes a day after the U.S. stock market suffered its worst one-day loss of the year.
The evidence from internal stock market data suggests they could be wrong. If history is any guide, the selloff may get worse. Much worse.
Monday’s selloff was notable in that it ended months of market calm. The Dow Jones Industrial Average was trading near the 18,000 level first reached in December. The CBOE Volatility Index (VIX), a measure of fear among traders, had been in hibernation since February.
The decline pushed the Dow back below its 200-day moving average, a measure of medium-term trend, for the first time since October while an exchange-traded fund that tracks the VIX posted its best one-day gain since 2011.
In other words, investors felt a tinge of emotion they haven’t experienced in a long time: panic.
Jason Goepfert of Sundial Capital Research notes that the Nasdaq Composite suffered a “shock day” selloff — a three-standard-deviation move coming on the heels of a 52-week high. Abrupt changes in market direction of this magnitude marked the last two bull market tops in 2000 and 2007, which is a scary precedent.
But before that, higher market volatility meant days like Monday came more frequently, and thus, they hold less predictive power about where stocks are headed. Yet it’s notable that shock days came before big market declines in 1984, 1987 and 1990. And it’s also notable that the market data suggests the shock days didn’t mark an imminent low; normally, it marked the initial phase of a more protracted pullback.
How bad could things get? History isn’t destiny, but Goepfert calculates that since 1971, the median decline over the next week or so following a shock day was in the 3% to 5% range.
His advice to investors: “It almost always paid to let the initial shock pass before trying to step in.”
Especially if this selloff follows the more recent pattern: One year after the shock selloffs of Nov. 7, 2007 and Jan. 4, 2000, the Nasdaq Composite was down 42% and 33% respectively.
My subscribers are prepared: Edge Pro readers are already carrying a 350% gain in their iPath S&P 500 VIX Short Term Futures TM ETN (VXX) July $17 calls recommended late last week.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters. Two- and four-week free trial offers have been extended to InvestorPlace readers.
