Italian Election Crisis Could be a Canary in a Coal Mine

Last spring wasn't perfectly analogous to now, but its close enough to set traders on edge

   

The politics of Italy are very complex and extremely unstable. Depending on your point of view, this is not necessarily a bad thing. There are many reasonable people who feel strongly that it shouldn’t be easy for government to get things done because when it is, politicians tend to do too much. However, that inefficiency can be double-edged. During times of crisis, complexity and instability can prevent a country from being able to deal with its problems quickly. Italy, which has had only one of its governments last the full 5-year term in the last 68 years, is facing a crisis right now and it’s not getting easier.

Election Crisis Underway

The Italian elections held last month are still essentially in limbo without a final resolution for who will serve as prime minister. This position must be confirmed by both legislatures and right now there isn’t a majority party or minority coalition in the Senate that can provide that confirmation. This situation can lead to another election and another round of uncertainty.

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You can see in the chart, where the S&P 500 (red and green) is compared to the iShares MSCI Italy Indexed ETF (NYSE:EWI) (black and white), what happened following the inconclusive Italian election last month. Stocks in North America recovered from the massive bearish engulfing pattern that appeared on Feb. 25 while the world reacted to the news, but Italian stocks did not. This matters because, like a canary in a coal mine, Italian economic disruptions are a warning for risk assets around Europe and the rest of the world.

It’s Not All About Equity

The comparison we have made between Italian stocks and the S&P 500 is not just about risk assets like equities. Although that is something we are very concerned about, instability in Italian stocks usually mirrors instability in Italian debt. Sovereign debt problems are really the biggest issue for the European economy. Even the relatively small bailout for Cyprus has caused reverberations around the globe as investors try to infer what will happen to Italy when their time comes.

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Italian bonds were down Wednesday on news that another attempt to form a government in Italy is failing. This has ramped up uncertainty and traders are taking some profits from stocks while U.S. bonds rally. Divergences like we have seen through the month of March are not a 100% predictor for wider disruptions, but based on past data, there is a strong bias in that direction. You can see a very similar divergence between Italian stocks and the S&P 500 that appeared about this same time last year in the chart below.

Eventually, U.S. stocks corrected lower in May 2012 once European instability (led by Greece) reached an apex and investors looked to take profits at high prices. To be clear, the situation last spring isn’t perfectly analogous to what we are seeing now, but its close enough to set traders on edge in the short term at least. Options can be very productive in situations like this when the potential for fast corrections (up and down) are higher.

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.


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