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Why the Stock Selloff is Just Beginning

As Egypt burns, market volatility spikes


Stocks are plunging on Friday in reaction to political turmoil in Egypt. With the financial news networks broadcasting images of chaos in Cairo, along with big declines on the major stock averages, I can’t help but think of the similarities between today and the May 6 “flash crash” meltdown that occurred during protests in Greece.

But really, the upheaval in places like Tunisia, Egypt, and Jordan is merely providing the catalyst for a selloff — the underlying conditions for a correction were already there. There have been plenty of signs over the last two weeks that investors were becoming overconfident and that stocks were rising on narrow support. I talked about some of these in my column this week as well as a blog post here.

So now what? By one measure, stocks appear to be entering their worst market correction since last summer. Here’s why:

eem index chart

For the benefit of the subscribers of my newsletter, the Edge, a few months ago I created a market direction and strength model that uses a variety of momentum and breadth measures. The tool, which I’ve dubbed the TREND Indicator, gauges the strength of rallies and corrections. And it also identifies major market turning points.

Today, on an intra-day basis, the model flashed its biggest sell signal since August 11 — which marked the beginning of the final summertime decline before the current five-month uptrend got started. The S&P 500 went on to lose another 4.6% before turning tail and moving higher.

Before that, you have to go all the way back to the April 27 selloff to see a sell signal of similar strength. The S&P 500 went on to lose nearly 15% in the months that followed.

To be sure, investors suddenly have a lot more to worry about.

Austerity measures in the United Kingdom has plunged their economy back into recession. Japan just had its sovereign credit rating cut for the first time in nine years as that country grapples with unsustainable debt loads, troublesome budget deficits, and an aging workforce — the same pressures faced by America and Europe. Inflation is forcing emerging market economies like Brazil and China to raise interest rates and tighten monetary policy. Earnings growth is set to slow. And the euro zone has yet to resolve the problems with Ireland, Greece, and Portugal as borrowing costs start to rise again.

For conservative investors, at the very least I recommend holding off on new stock purchases. Ideally, they would increase their cash allocations to protect against continued declines. I would continue to avoid bonds, despite the bounce they may see due to safe haven buying in the coming weeks, because the long-term outlook for fixed income investments is cloudy at best.

For short-term traders, I recommend looking for short ideas in the emerging markets. Not only are the stocks of places like China and Brazil suffering as policymakers there grapple with rising inflation (just look at the spike in China’s inter-bank lending rate, but foreign stocks will suffer as investors push up the dollar. This happens when hedge funds and other institutional traders move out of foreign assets due to currency translation losses.

Good candidates include the ProShares Short Emerging Markets (NYSE: EUM) and the ProShares UltraShort Brazil (NYSE: BZQ). For more specific ideas, look at these two Brazilian bank stocks: Banco Bradesco (NYSE: BBD) and Itau Unibanco Banco Multiplo S.A. (NYSE: ITUB).

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned. He has recommended BZQ and EUM to his newsletter subscribers. Be sure to check out Anthony’s new investment advisory service, The Edge. A two-week free trial has been extended to Investorplace readers.

The author can be contacted at Feel free to comment below.

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