Markets nose dive – whats happening? Equities cratered and were down 1.8 percent for the week. The S&P 500 has staged its biggest two-day slide since June 20, and Treasuries are on a tear, in what appears to be the return of the classic “risk-off” trade. What is going on and is time to panic?
The big question that everybody is trying to get their head around is: “Is this the correction that is the buying opportunity or are we setting up for something that is really scary?” A signal that the selling may be overextended, investors were willing to pay more for protection against a drop in the S&P 500 today than three months down the road. The last time the spread between the CBOE volatility index and three-month VIX futures turned negative was last October, shortly after a 4.8 percent pullback in the S&P 500, that opened the door to the last leg of the 2013 market rally.
Now to the reasons for the sell off. Some have said that earnings have been coming in a little soft. But Thomson Reuters data through Friday morning showed earnings for the fourth quarter are expected to grow 7.5 percent – not bad. Of the 122 companies in the benchmark S&P 500 index that have reported results so far, 63.9 percent beat expectations, slightly above the long-term average of 63 percent.
Everyone seems to be pointing to the disappointing manufacturing data out of China last Thursday. The market finally woke up to the fact that emerging markets are slowing. The flash Markit/HSBC Purchasing Managers’ Index (PMI) fell to 49.6 in January from December’s final reading of 50.5, dropping below the 50 line which separates expansion of activity from contraction. This was a bit of a shocker to some that think China can do not wrong.
Emerging-market currencies continued to tank on Friday, amid growing worries about political upheaval, slowing growth and U.S. monetary policy, prompting central bankers and policymakers to scramble. Turkey’s lira hit a new record low against the dollar, and Argentina’s peso was down almost 20 percent on the week against the dollar. Turkey and Argentina are said to only have a few weeks of foreign dollar reserves – yippes! The Indian rupee fell to a two-month low against the dollar, and traders said the central bank had intervened in the currency markets. Mix in a little social unrest in Ukraine and Egypt, and the emerging market story looks fragile.
However, what really is driving the sell-off is a massive unwinding of levered bets in the hedge fund community that were placed on views which have come to the point that the markets have become very one-sided lately. Everybody was long equities and short Treasuries. We can see this also in other markets as well. A mysterious and violent movement in crude oil prices has traders scratching their heads in disbelief. Gold, Natural Gas and some currencies are on the list as well. So the big hedge fund unwind has started and could extend a bit more.
So what are we to do? Technically we have done some damage and the technical traders will be reluctant to get back in long here. We closed on the low of the day last Friday, and that usually is a sign of more to come. Most of the moves are from the fast money. Longer term investors woke up, but are still largely long. My guess is we are in for a 2 to 4 week negative period – so the “risk-off” trade should be the short term state of play. We very well could set up a massive rally to new highs once this negativity works itself out, assuming the macroeconomic situation does not changes significantly. For now the positive macro trends are still in place, but do bear watching.
Blue Point Trading, William Thompson