Why are stocks swooning?

The Dow Jones Industrial Average was pummeled on Thursday, testing its 50-day moving average for the first time since September as all the confidence and excitement that drove the index to a new record high on New Year's Eve has faded.

A weaker-than-expected Chinese factory activity report was blamed. But there's more to the story.

This marks an acceleration of the slow burn selling seen all month long as disappointing fourth quarter earnings results rolled out and officials from the Federal Reserve kept reminding investors that its ongoing QE3 bond purchase stimulus will be rolled back.

With two big assumptions that drove stocks higher throughout 2013 threatened -- unstoppable corporate profitability and an unlimited flow of cheap money stimulus -- investors took a pause. Now, they're headed for the exits as the overall sense of malaise is spreading.

It started, and it's accelerating, because of what's happening in Asia.

China has been leading the way down lately, with the Shanghai Composite Index down 10 percent from its high in early December as a number of negative catalysts have weighed. I recently discussed the growing problems in China's shadow banking system as authorities in Beijing desperately try to tamp down on risky lending.

Yet this is just one facet of a problem that is increasingly manifold including the need to reorient away from export dependence, the overbuilding of infrastructure, overcapacity in capital intensive industries such as steelmaking, and the erosion of China's role as the world's cheap labor hub was the number of available workers starts shrinking due to demographics, pushing up wages.

So when it was reported during the Asian trading session that the Chinese PMI Flash Manufacturing Index dropped to 49.6 vs. the 50.6 consensus estimate and the 50.5 reported in December, it stoked fears that perhaps the communist bureaucrats in charge of the Middle Kingdom won't be able to painlessly solve all these problems.

Any reading under 50 indicates a month-over-month contraction in activity. The index was dragged down by lower domestic demand, which is a problem as Beijing has been trying to simultaneously reduce their economy's over reliance on exports, infrastructure building, cheap credit, and a cheap currency.

Another problem out of Asia dragging on U.S. stocks is the reversal of the yen carry trade.

The carry trade is when hedge fund types sell the yen short and use the proceeds to dabble in U.S. and European assets. That's fueled the meltup in stocks since October and has made the major averages very sensitive to the movements of the yen, often mirroring its movements tick-for-tick during the trading session.

Today, the yen carry trade, as represented by the ProShares UltraShort Yen (YCS), collapsed below both its lower Bollinger Band and its 50-day moving average -- the most significant downtrend initiation since June. The scramble to cover positions funded by yen carry trades is why the selling in stocks suddenly became so frantic.

And finally, heading into February, we are faced with new worries as the debt ceiling fight is set to rev up again -- starting with President Obama's State of the Union address next week.

Given all this, the selling pressure is likely to continue. I've recommended investors take refuge in safe havens such as cash or Treasury bonds, which are rebounding. The iShares 20+ Year Treasury Bond Fund (TLT) is poised to push over its 200-day moving average for the first time since April. In response, I've added the leveraged Direxion 3x Treasury Bond Bull (TMF) to my Edge Letter Sample Portfolio. The position is up nearly seven percent since January 10.

Disclosure: Anthony has recommended TMF to his clients.  

Anthony Mirhaydari is founder of the Edge, an investment advisory newsletter, as well as Mirhaydari Capital Management, a registered investment advisory firm.




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