The market snaps back to reality

Perhaps still recovering from their New Year's celebrations, investors faced an icy blast Thursday as stocks suffered their first major selloff since early December. For now, dreams of Dow 17,000 must wait.

The catalyst for the pullback wasn't anything in the news or in the batch of global manufacturing activity reports that were released. Instead, it was all about the "yen carry trade" -- the currency trade that's been providing vital support to an uptrend that had, based on narrowing technical support and uncommonly bullish sentiment, grown increasingly vulnerable. Hedge fund investors have been relying on the steady decline in the Japanese yen against the U.S. dollar and the euro to provide funding for speculative purchases of stocks and corporate bonds.

As long as the yen keeps falling and the dollar and the euro remain strong, the trade works. And you can see the connection in the way the stock market often mimics the vagaries of the yen carry trade tick for tick.

But when the trade reverses, it encourages a wave of yen buying and dollar and euro selling as traders fight to be the first out the exit. Stocks suffer as a result. That's what's happening now as the yen carry trade, specifically the euro-yen currency pair, suffers its largest one-day loss since June.

The selling is washing over the market like a wave. Emerging market stocks, represented by the iShares Emerging Markets (EEM), have been pounded back below both its 50- and 200-day moving averages and have returned to their November lows. Crude oil is also suffering its largest one-day loss in 13 months. Junk bonds, which ignored the stock market melt-up of the last few weeks, look vulnerable to a breakdown.

All of this comes as measures of investor sentiment had reached levels associated with major market turning points. The Investors Intelligence survey shows that there are four times as many bullish money managers as bearish ones. That ratio far exceeds the peaks reached when the market was topping in 2007 and 2000.

With sentiment so one-sided, with the market so dependent on the vagaries of the currency market, and with commodity and bond markets under pressure, 2014 is already off to a rough start after 2013's bumper year.

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I'm recommending a cautious approach, with an emphasis on the improving outlook for precious metals as gold, silver, and the related mining stocks perk as shown above. If you're looking for metals exposure, consider the the ProShares Ultra Silver (AGQ) or the unleveraged iShares Silver (SLV).

Disclosure: Anthony has recommended AGQ to his clients and added it to his sample portfolio, which you can view here.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.

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