Geopolitics rattles complacent investors

It was all going so well. Federal Reserve Chair Janet Yellen was in front of Congress this week brandishing her dovish tendencies. Large-cap stocks are pushing to new highs. All was right in the world.

It's all changed on Thursday as the air of calm was shattered by a breakdown in the geopolitical realm.

The market had been ignoring the situations in Iraq, Israel and Ukraine for weeks. But in echoes of the energy price shocks of the 1970s, the problems can't be ignored any longer. Cheap money stimulus, while powerful, can't fix all things -- especially not war.

First, Ukraine claims a Russian-made surface-to-air missile streaked through the East Ukrainian sky and, in a flash, ended nearly 300 lives at 30,000 feet when it brought down a Malaysian 777 airline bound for Kuala Lumpur. The pro-Russian separatists deny they're responsible and are blaming Ukraine. While it'll likely take a while to determine what actually happened to Flight 17, it's clear this tragedy is going to escalate the conflict and surrounding tensions -- especially in the wake of yesterday's new U.S. economic sanctions against Russia.

Then, Israeli Defense Forces deployed ground forces into the Gaza Strip, with the support of air and naval assets, in response to ongoing rocket attacks. Targets will include underground tunnels terrorists use to transport men and material.

And if all that wasn't enough, the White House went on lockdown near the close of the trading session on reports of a suspicious package.

The result was an explosion of volatility, which Fed officials have publically worried about being a sign of market complacency, as the CBOE Volatility Index ( VIX) gained nearly 33 percent. That's the largest one-day gain, in percentage terms, since April 2013 in response to the horror of the Boston marathon bombing.

071714rut.png

Significant technical support was taken out in the process, with the Russell 2000 small cap index closing below is 200-day moving average (chart above). Aside from a quick excursion below that level in March and April, it has held that line since 2012. A move below 1,125 would take the Russell under its 50-week moving average, a level it hasn't been below in a meaningful way since November 2012.

071714ibb.png

Areas of recent weakness, such as biotechnology, were hit hard with the iShares Biotech ( IBB) losing 2.2 percent as it dropped back below its 50-day moving average (chart above). Investors moved into safe havens, including long-term U.S. Treasury bonds, pushing the iShares 20+ Year Treasury Bond (TLT) up and over its May high, pushing out of a multi-month trading range.

071714hyg.png

Even the corporate bond market is coming under pressure, with junk bonds represented by the iShares High Yield Corporate Bond Fund ( HYG) suffering its worst wipeout since last summer (chart above) on a combination of risk-off tendencies, overvaluation warnings from Fed officials and the realization that the Fed's QE3 bond-purchase stimulus remains on track to end in October.

071714rsx.png

And finally, Russian stocks were hit hard on the Malaysian airliner news and as it sank in that the U.S. sanctions announced on Wednesday -- which will limit Russia's ability to raise capital in the global debt markets -- will squeeze Russia's economy. The Market Vectors Russia ( RSX) suffered a big 7.2 percent decline as it dropped below its 50-day and 200-day moving averages (chart above).

For investors, the best advice is to book some profits and move to a more defensive portfolio positioning because geopolitics, by nature, is unpredictable. Moreover, the stock market is fully priced with the cyclically adjusted price-to-earnings ratio on the S&P 500 at levels that have been exceeded only in 1929, 2000 and 2007.

For more aggressive investors, I've recommended a couple of targeted leveraged inverse funds to take advantage of the situation. Examples include the UltraShort Biotech ( BIS), which is carrying a gain of nearly 9 percent after being added to my Edge Letter Sample Portfolio on July 8, and the Direxion 3x Russia Bear (RUSS), which gained nearly 22 percent today and has been added to that portfolio.

Disclosure: Anthony has recommended BIS and RUSS to his clients.

  • 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.