The bulls have got blood on their nose now — something they haven’t experienced for a couple of years. And it’s likely to get worse.
That’s the takeaway from the stock market’s dive on Tuesday, with the Dow Jones Industrial Average losing 1.6% to take the index back below its 50-day moving average on a combination of disappointing economic data out of the eurozone, nagging fears about China, and evidence that the U.S. job market is tightening — which will put pressure on the Fed to pull back its cheap money stimulus.
Although the Dow has been trying to soothe investors by remaining above its August lows, and is down just about three percent from its record high, it’s masking deeper weakness. Everywhere else you look, the situation looks much worse. Consider that the Russell 2000 small cap index is now down more than seven percent for the year-to-date.
But the Russell’s decline is hardly the only worrisome signal. Here are five reasons the selling isn’t over yet.
Selloff Signals: Breadth
The more you look, the more it seems like the stock market really peaked back on July 3 — ahead of the Independence Day holiday when the Dow closed above the 17,000 level for the first time. Since then, it’s been a slow decay.
Consider market breadth — or the number of stocks participating to the upside. It hit a high in July and has been moving lower ever since. Back then, nearly 85% of the stocks on the NYSE were above their 50-day moving averages. This dropped to 65% as the market rebounded from its August lows. Now, it stands at just 25 percent.
That’s a sign that the Dow is being held aloft by sticks and twine.
Selloff Signals: Europe
The eurozone kicked Tuesday off on a dour note after German industrial production crashed at a 3% annual rate in August — the worst performance in nearly six years. On a monthly basis, output dropped at its steepest decline since January 2009 at the height of the great recession.
This is just another indication that something very wrong is happening in Europe, which never really fixed the fundamental problems underpinning the debt crisis that nearly shattered the currency union back in 2012.
The Europe 350 iShares (IEV) double-topped in June and July before starting a long slide lower amid economic stalling and lost confidence in the ability of the European Central Bank to fix the problem with more monetary stimulus. The IEV is down 8% already.
Selloff Signals: Japan/Currencies
Another big driver of Tuesday’s decline was a pullback in the “yen carry trade” — or the relationship between the Japanese yen and the U.S. dollar. Since the current uptrend started in 2012, the stock market has closely followed — often tick-by-tick — the moves in these two currencies.
Stocks rallied out of the August low helped in large part by a surge in the yen carry trade driven by a weakening of Japanese economic data in the wake of the largest sales tax hike there since the 1990s. That’s because hedge fund types will borrow in yen to invest in stocks. As long as the yen is weak, the trade works.
But now there is sense that things have gone too far. That, along with a lack of new stimulus action by the Bank of Japan overnight, sent the dollar down against the yen and hit yen carry trade positions.
Selloff Signals: The Fed
Investors are also growing nervous over the realization that the Federal Reserve’s QE3 bond buying stimulus — which was launched in late 2012 and has supported the market over the last two years — is coming to an end. On Wednesday, the Fed will release the minutes of their September policy meeting.
It’s expected to contain details of the debate within the Fed on the pace and timing of monetary policy tightening — something investors haven’t contended with since 2006.
Tuesday’s job openings data (most openings since 2001), along with the drop in the unemployment rate to 5.9% last month (which was the Fed’s year-end target), will increase the pressure on the Fed to tighten sooner.
Selloff Signals: Technicals
On a technical basis, Tuesday’s decline took the NYSE Composite back below its 200-day moving average.
While this may not seem like that big of a deal — merely a line in the sand — this level has supported the NYSE Composite during the June 2013, February 2014, and August 2014 pullbacks. People have been paying attention to it as an important level the bulls wouldn’t tolerate a move below.
But that has changed now, suggesting the bears are in control now.
What Now?
Given the volatility that has hit not only stocks but corporate bonds, Treasury bonds, commodities, and currencies, it’s hard to find a safe haven these days. For conservative investors, the best advice is to raise your cash allocation and watch the fireworks from the sidelines.
For the more aggressive, rapid declines in stocks that haven’t seen significant selling pressure for years is creating new profit opportunities on the downside. One example is Ford (F), which has been pummeled on a profit warning on weakness overseas. The October $17 puts I recommended to Edge Pro subscribers back on September 8 are now up nearly 464% with room for more.
New recommendations include put option positions against stocks like AIG (AIG), which are dropping below major support levels. In fact, AIG hasn’t crossed below its 50-week moving average, as it did on Tuesday, since 2011.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.
