This week Italy dodged a potential deal-killer when their debt auction went off without serious issues. The country auctioned 10-year bonds at a yield of 4.83%, which is not terrible considering the uncertain status of the election and government.
The question that needs to be asked at this point is whether the smaller-than-expected decline in Italian bonds means that “this time is different.” Anything is possible, and there have been false alarms before (e.g. November 2010), but the probability of a decline in U.S. and European stocks following a decline in European sub-prime bonds is too strong to completely ignore.
False Alarm or True Breakout?
For those of you unfamiliar with how bond yields work, they are the inverse of a bond’s price. If a bond is considered weak, its price will fall and its yield will rise. The yield on Italian debt is surprisingly high right now, which means that its bonds are considered relatively weak despite being propped up by the European Central Bank. However, this is a razor’s edge and a break toward even higher yields is still in the cards and would trigger ripple effects around the financial markets.
While there is no way to be absolutely certain that the market will follow sub-prime European debt, there are a few things to watch that may increase our confidence over the next week or so. The list below is not comprehensive but represents a good cross-section of confirming (or refuting) indicators to watch as we head towards the first few weeks of March.
Three Areas to Watch
Small Cap Stocks with Exposure to Europe: Small-cap and growth stocks in general tend to be more sensitive to market uncertainty than the large-cap indexes. For example, one sub-sector that we watch very closely is solar. The group is dependent on the largess of European and Asian governments and any signs of weakness there will scare traders off. Both First Solar (NASDAQ:FSLR) and Trina Solar (NYSE:TSL) sold off hard following earnings reports yesterday that included very sour outlooks. These firms have a similar leading relationship with the large cap stock indexes and should be watched closely.
Transportation Stocks: There is a tendency for transportation stocks to lead large caps down before a big decline. Earlier this week, the two indexes were moving in tandem to the downside but that has reversed today with a very BIG day for transport stocks. Much of the gains have been concentrated disproportionately in a few companies like Kansas City Southern (NYSE:KSU) and JB Hunt (NASDAQ:JBHT), but nonetheless there seems to be some momentum emerging. If transport stocks continued their rally beyond last week’s highs we would be much more confident about a continued rally market-wide.
Click to Enlarge U.S. Treasury Bonds: The “best” bonds in the market have a strong tendency to rise in value before and during a break in stocks. They are considered a safe-haven investment and can tell us a lot about the potential flow of capital out of stocks. The US Treasury 20+ Year Bond ETF (NYSE:TLT) had a great day on Monday this week and is even up a little in the early session today but hasn’t formed a higher high yet. It is not uncommon for bonds to rally three to four weeks before the stock market sells off. New highs would be a key indicator that sentiment is changing and investors have become very fearful.
We are still expecting an uptrend in the long term but a short-term correction (3%-5%) is probably unavoidable. We have increased the number of bearish positions open in our Slingshot Trader portfolio this week as we expect that correction to occur at some point over the next several days. The sequester, European uncertainty, and slowing in Asia are all pointing to a “profit taking” opportunity for longs and that seems most likely to happen over the next week or two.
However, we don’t want to be exclusively contrarian. A correction is likely to be concentrated in the weakest and smallest stocks. Stronger firms offer excellent opportunities to buy on dips. We are evaluating several bullish positions right now for this week despite the very real headline risk in the market.
John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.