Of the potential problems that could turn this flat-to-bullish market into a bearish one, an implosion in emerging markets with spillover effects in Europe is near the top of the list. While we wouldn't characterize the problems in Turkey as a crisis of that magnitude yet, it is starting to get a little closer.
As you can see in the next chart, The Turkish lira (TRY) is falling rapidly against most developed-nation currencies like the U.S. dollar (USD).
TRY/USD exchange rate: Chart source - TradingView.com
The problem can be understood by imagining a feedback loop of investors in emerging markets moving money into safe-haven assets (like European and U.S. Treasury bonds) and out of economies like Turkey.
That flow of capital reduces the value of Turkish assets (bonds, currency, stocks, etc.), which increases interest rates even without action by the central bank, which worsens financial conditions further and results in even more investors moving their money out of the economy.
If the spiral persists for long enough, the currency could collapse completely. This happened in 2001, when interest rates in Turkey spiked to 3,000% and one dollar was worth 1,500,000 lira. This is obviously bad news for Turkey, but it also has the potential to impact U.S. and European markets as well. We believe it is not a coincidence that the lira's collapse in February of 2001 was correlated with the already fragile markets in the U.S. and Europe breaking support and beginning the worst phase of the dot-com bust.
A crisis in one country tends to affect investor sentiment in similar countries around the world. In the case of Turkey, its proximity to Europe's most fragile economies (Greece, Italy and Spain) can create a real problem. If trade between those economies slows because there is a financial crisis in Turkey, it may be enough to tip the balance closer to an emergency in Italy or Greece.
A reduced appetite for risk assets in Europe tends to lead to the same problem in the U.S., Japan and the U.K. as well. Keep in mind that the Asian financial crisis of 1997 (which lead to a 15-year period of stagnation in Japan) was triggered by a collapse of the Thai currency (THB).
If a crisis emerges, it could spread, and that will make investors nervous, which was probably the rationale behind yesterday's selling in banking stocks.
The Bottom Line
The topic of this article may sound alarming, but we have to keep in mind that a worst-case scenario, in which U.S. stocks enter a bear market, would take some time to form. The important concept to understand this week is how fear of a crisis can add volatility to the market and why that happens. The Turkish economy hasn't imploded yet, but if things get worse, we recommend traders remain nimble enough to make changes that allow them to take advantage of that volatility.
You can learn more about identifying price patterns and using them to project how far you think a stock is going to move in our Advanced Technical Analysis Program.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, 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 SlingShot Trader trade and get 1 free month today by clicking here.
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