4 Reasons the Selloff Will Continue

by Anthony Mirhaydari | April 7, 2014 1:20 pm

It was all going so well.

Brown Bear stocks to sell[1]
Source: Flickr[2]

Stocks were ignoring the weakness in big tech and biotech stocks. The large-cap indices were flirting with new record highs. January’s emerging-market wipeout and February’s Ukraine volatility were long forgotten.

The bulls ignored skeptics like me pointing out diminishing participation as fewer stocks ramped to new highs, an over-reliance on the yen carry trade and signs that amid overconfidence and complacency, fundamentals like earnings and macroeconomic data were rolling over.

That all changed Friday as the Nasdaq-100 suffered its worst intraday reversal in years[3]. In the process, it violated three-year-old uptrend support as it closed beneath its 20-week moving average for the first time since 2012.

The problem wasn’t the March jobs report, which came in slightly below expectations. It was rumors out of Europe that the European Central Bank could be preparing to unleash cheap-money stimulus of its own.

While normally that would be good news for this liquidity-addicted market, in the bizarro world that passes for free market capitalism these days, it wasn’t. That’s because the news pushed the euro down against the yen, pinching yen carry trade positions and forcing hedge funds to sell their stocks and other risky positions to close their carry trades (which are short yen/long euro pair trades).

While Friday’s wipeout — which is continuing as I write this on Monday — was painful, the evidence suggests the selloff isn’t finished yet. Here are four reasons why, as well as how to play continued weakness,:

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Momentum Stocks

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The sweetheart momentum stocks of 2013 are causing a lot of tears early in 2014 as many popular holdings in the big tech and biotech sectors roll over into bear markets.

Over the weekend, Reuters warned that despite the fact many of these names have dropped into bear markets of their own — with Facebook (FB[5]) down nearly 22% from the high reached less than a month ago — valuations in the sector are still extended. FB trades with a price-to-sales ratio of nearly 20, making it the most expensive stock in the S&P 500, which has an overall ratio of just 1.7.

These trades are among the most popular holdings among hedge funds, which are being pinched by the weakness in the euro.

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Participation in the surge to new highs by the S&P 500 last week was narrow, with fewer than 8% of the constituent stocks also moving to new highs. That’s a sign of weakness and a lack of conviction in the move. More than 300 were more than 3% away from a new high last Thursday before Friday’s wipeout.

When the S&P 500 hit a record back in May 2013, it did so with nearly 40% of its components participating. Over the last 10 years, such a narrow rise to new highs happened 10 other times. Only two managed to hold onto additional gains over the days, weeks and months that followed (September 2006 and January 2013).

The chart above shows how the percentage of S&P 500 stocks in uptrends has been mired in a pattern of lower highs and lower lows all year.

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Economic Data

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Adding to the pressure has been a steady drip of disappointing economic data, which suggests that maybe the slowdown we’ve seen in recent months cannot just be blamed on harsh winter weather.

Perhaps it’s indicative of deeper trouble.

Some of the data last week was soft, including reports on manufacturing activity and the trade deficit.

That caused another downward shift in the Citigroup Economic Surprise Index, which measures where the data is coming in against analyst expectations. We’re now looking at the most disappointing period in the macroeconomic data since 2012.

Amid the continuation of the Fed’s tapering of QE3, and the bringing-forward of the timing of the first short-term rate hike, this is about as comforting as a cold, wet towel.

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Yen Carry Trade

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Finally, let’s go back to what happened on Friday.

Stocks have been supported over the last few years by the popularity — especially among hedge fund types and other institutional traders — of currency carry trades. This is where people would short a weak currency like the yen, then buy assets in a rising currency like the euro. This explains why the Spanish five-year bond yield dropped below the five-year U.S. Treasury note yield last week.

On Friday, carry trades got hit hard by rumors out of the German press that the European Central Bank was modeling the market impact of a 1 trillion-euro bond-buying stimulus program[6]. They wanted to see if it would reverse the slide in inflation and credit growth that is plaguing Europe at the moment.

While on the surface, this would appear to be good news for the bulls (more cheap money!) it pinched yen carry trade positions that relied on a relatively more aggressive Bank of Japan and a more stringent ECB; which, in turn, would result in a steady drop in the value of the Japanese yen against the euro.

The possible shift in the relative policy stances of these two major central banks upset these pair trades, forcing hedge fund types to scramble to close their positions by selling stocks and other risky assets, selling euros and buying yen. That, in turn, worsened the moves for others with the same exposure. Selling begat more selling.

Another factor has been the rise of damaging food and fuel price inflation in Japan, which is hurting consumer confidence and is a nasty side effect of the currency devaluation strategy being used — as a last-gasp effort — by policymakers in Tokyo trying to reverse the country’s decades long stagnation.

That decreases the odds that the Bank of Japan will look to weaken the yen with more stimulus in the near term. At this point, the cheap money is becoming counterproductive.

A similar dynamic with yen carry trades played out in the market’s rush to the last bull market peak in 2007.

How to Play It

In response, I’m recommending clients move into safe haven assets like U.S. Treasury bonds and the CBOE Volatility Index (VIX[7]) for production. Highlights in the Edge Letter Sample Portfolio[8] include the Direxion 3x Treasury Bond Bull (TMF[9]). For the more aggressive, I’ve also recommended put option positions against big tech stocks like Facebook. The April 65 puts I recommended on March 21 are up nearly 400% since then.

Anthony Mirhaydari is founder of the Edge[10] and Edge Pro[11] investment advisory newsletters, as well as Mirhaydari Capital Management[12], a registered investment advisory firm. As of this writing, he has recommended TMF and FB puts to his clients.

  1. [Image]: https://investorplace.com/wp-content/uploads/2011/09/Brown-Bear.jpg
  2. Flickr: http://www.flickr.com/photos/28744394@N08/4585176887/
  3. Nasdaq-100 suffered its worst intraday reversal in years: https://investorplace.com/2014/04/qqq-nasdaq/
  4. Compare Brokers: https://investorplace.com/options-trading/broker-center/
  5. FB: http://studio-5.financialcontent.com/investplace/quote?Symbol=FB
  6. 1 trillion-euro bond-buying stimulus program: https://investorplace.com/2014/04/european-dividend-stocks-yield/
  7. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  8. Edge Letter Sample Portfolio: https://www.edgeletter.com/sample.php
  9. TMF: http://studio-5.financialcontent.com/investplace/quote?Symbol=TMF
  10. Edge: http://www.edgeletter.com/
  11. Edge Pro: http://www.edgeletterpro.com/
  12. Mirhaydari Capital Management: http://www.mirhaydaricapital.com

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