Stock market at a crossroads

How quickly things change.

Last week the market was on a tear, led by the Russell 2000, which surged dramatically to new all-time highs after Russian President Vladimir Putin seemed to de-escalate the tension in Ukraine. This capped a 12 percent rise out of the February low set during the scare over emerging markets. But only days later the index was on its worst sosing streak since May 2012, falling five days in a row in a steady drip-drip of selling pressure.

After stocks climbed ever higher through the first two months, several factors are now bring them back to earth.

First, the situation in the Ukraine has warmed up again, heading into a Crimean referendum on independence from Kiev set for Sunday. The West is criticizing this as a sham, with President Obama repeating calls that there will be "costs" for Russia if it annexes the region, should citizens vote to enter Moscow's embrace.

Second, the credit situation in China has taken a turn for the worse, with copper futures plunging on a scale not seen since the 2011 wipeout connected to the loss of America's AAA-credit rating, or the Lehman Brothers collapse before that. Copper has been popularly used as collateral in shady financing deals for years, and with Beijing trying to tamp down on excessive credit creation, metal prices are collapsing. The metal is down nearly 11 percent from its February high.

China on Thursday announced a greater-than-expected slowdown in industrial production, which could further weigh on financial markets.

"China's January-February activity data all came in vastly below our below-consensus forecasts, confirming the fast deterioration of China's economic growth entering 2014," Societe Generale economist Wei Yao said in a research note. First-quarter "GDP growth falling below 7.5 percent is now pretty much certain, and something barely above 7 percent looks quite likely."

Third, Japanese investors have been disappointed of late at the Bank of Japan's reluctance to stimulate the economy with another infusion of cheap money. The Japanese are in a bind, caught between the negative side effects of their obsession with currency devaluation (higher import prices, higher inflation, weaker trade balance) and the positives they're still waiting for (more competitive exports, higher wages). Throw in a persistent government budget deficit and massive indebtedness, necessitating a confidence-crushing tax hike proposal and the situation looks grim.

All things considered, there seems to be all the reason in the world for investors to sell stocks and play it defensively. Especially since, here at home, the Federal Reserve seems committed to continuing its tightening of its monthly bond purchases at its upcoming policy announcement on March 19, which will feature Janet Yellen's first press conference as Fed chair.

Yet an argument could also be made that, given the selloff we've seen over the past week, some upside extension is possible that could potentially push the Dow Jones industrial average to new all-time highs. A 250 point gain would be enough to do it.

One reason is that the U.S. dollar, which acts as a safe haven asset in times of worry, has been consistently weak lately; reversing the strengthening trend seen between December and January that put pressure on emerging market currencies by encouraging capital outflows. If the greenback keeps falling, it will provide a modicum of relief to the emerging markets stocks that drove the decline into the February low in the first place.

For another, Federal Reserve officials continue to shift the focus away from tapering to a concept known as "forward guidance," which is essentially a promise to keep short-term rates lower for longer. The gist of this is that while the unemployment rate has fallen, other measures of the labor market -- such as part-time employment, the rate at which workers quit their jobs and labor force participation -- suggest a lot more healing is needed.

That means short-term interest rates could remain near zero into 2016, as many analysts expect. After 2013's easy market gains, in other words, 2014 is already proving to be a much trickier animal. Investors need to stay on their toes.

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm.


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