Market Upheaval: Vicious Correction or Major Turning Point?

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Investors have been reminded of the unpredictable and unstable nature of the financial markets. A month ago, markets were characterized by low volatility, steady appreciation in risk assets, and a sanguine mood about the economic environment. In recent weeks, we have had a déjà vu of the deflationary collapse and panicked flight from risk of late 2008 and early 2009. The S&P 500 is down 11% from its April high. A broad index of foreign stocks is down 15% in U.S. dollar terms from its April peak.

There has been a flight to U.S. treasuries and the U.S. dollar, just as there was in the frantic deleveraging of the last bear market. The 10-year treasury yield has fallen to 3.2%, a 52-week low, from an early April high of 4%. As investors have fled the euro, and have unwound "carry-trade" positions in higher yielding currencies like the Australian dollar, the U.S. dollar index has climbed to its best levels in over a year. The question on everyone's mind is whether the upheaval of the past three weeks is a vicious correction or a major turning point in global financial markets.

Things are moving quickly, and the next few weeks will tell us a lot, but at this point we are leaning towards the latter interpretation, which implies that we will be looking for opportunities to reduce risk in portfolios. Confidence in markets, governments, and financial institutions is shattered; attention is focused on the unsustainable fiscal condition of the major developed economies of Europe, Japan, and the U.S.; and risks are rising of a downside reversal in the global economy. Investors are flocking to U.S treasury bonds as a perceived safe haven should note that the U.S. debt-to-GDP ratio is 93%, which is higher than all three major European economies, including Germany (77%), France (82%), and the U.K. (80%).

The technical condition of the equity markets is facing a critical test, which makes the coming week's market action very important. The S&P 500 made a constructive reversal on Friday, closing the week at 1087, 17 points above the panic intra-day low at 1070 on May 6th,. More importantly, the index has held above the February 8th closing low of 1056 (Exhibit 1). [ click to enlarge charts ]

Exhibit 1

A violation of the February low would have quite negative technical implications, because it would imply bear market price action rather than a deep correction. Unfortunately, most foreign stock markets are already exhibiting bear market patterns of lower highs and lower lows (Exhibit 2).

Exhibit 2

The behavior of the Chinese stock market, which peaked last July and has recently plunged to new lows, is particularly troubling and has negative connotations for the global growth theme (Exhibit 3).

Exhibit 3

Exhibit 4

Exhibit 4 illustrates the degree to which breadth has crumbled in the market carnage of the past several weeks. The percentage of New York Stock Exchange stocks trading above their 200-day moving average has plunged from 85% in late April to 47% following Thursday's close. This is the first reading below 50% since last May. This indicator could quickly move back above 50% if we get a sharp relief rally in the markets. For now, it illustrates how much technical damage has been done in a short period of time. Stocks are oversold to the extreme, and key short-term technical indicators, such as the VIX volatility index and equity put/call ratios, have reached levels comparable to October 2008 and March 2009 (Exhibit 5), suggesting that an upward reversal in markets is imminent.

Exhibit 5

It is possible that reversal started on Friday or it is possible that the selling pressure may continue into next week before a relief rally develops. If we become increasingly convinced that the highs for the bull market cycle that began in March 2009 were put in place last month, our strategy will be to use counter-trend rallies to incrementally reduce risk in portfolios. Our best guess is that the stock market is very close to making a short-term bottom, but there might be a final wash-out first, and once that bottom is defined, the market will have a relief rally that will provide an opportunity in the weeks ahead to get into a somewhat more defensive posture for what looks to be a more hostile market environment, perhaps for the balance of the year.

The European response to its sovereign debt crisis essentially follows the script employed in the U.S. - bail out the banks (the principal holders of the debt of mismanaged European economies) with taxpayer funds financed through budget deficits, and engage in monetization operations whereby the central bank intervenes to support debt markets. This is unequivocally bullish for gold in the medium to longer term, and investors should use corrections to add to their gold positions. Another bullish support for gold is that as a result of the events of the past several weeks, there is likely no chance that the U.S. Federal Reserve will hike the fed funds rate in 2010, and may well hold rates at near-zero levels well into 2011.

See also 3 Key Drivers for Stocks, Commodities, Forex, June 13 - 18, 2010: Outlook Remains Bearish on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , US Markets

Referenced Stocks: DIA , QQQ , SPY



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