It's been a stressful few weeks in the market. We've had currency turmoil; disappointing economic reports; a bailout of a troubled investment trust in China, multiple surprise interest rates hikes out of the emerging markets as policymakers desperately try to stabilize exchange rates; and another $10 billion taper from the Federal Reserve.
As a result, through Wednesday the Dow Jones industrial average has fallen 5.3 percent from its New Year's Eve high in what's been the worst sell-off since the debt ceiling scare back in October. The obvious question for investors: Will stocks continue to fall, or is this a buying opportunity?
Like so much in life, an easy answer is illusive.
On a technical basis, market breadth has weakened to levels not seen since back in June, with just 70 percent of S&P 500 companies in up trends. So by recent standards, that's pretty oversold and could represent a buying opportunity. This could explain why stocks rebounded on Thursday, with the Nasdaq Composite, which hasn't finished below its 20-week moving average since 2012, leading the way.
Still, this is a far cry from the truly oversold conditions we saw in 2011, when only 20 percent of stocks in the S&P 500 were in up trends amid panic from the loss of the U.S. government's AAA credit rating. Things also look less overheated than 2012, when only 45 percent of stocks were in up trends as people worried about the future of the eurozone.
So then the question becomes, is the market's apparent invulnerability to more serious declines still in play?
Doubtful. The catalyst for the 2013 market melt-up, which was the most persistent and stress-free rise since the final phase of the dot-com bubble, was the unencumbered flow of cheap money into the global financial system. Mainly, the funds were coming from the Federal Reserve and the Bank of Japan.
This pattern is now in jeopardy. The Fed is scaling back its bond
purchase program and is on track to pull the plug altogether later this year. In Japan, the government is now shying away from more
stimulus because the resultant weakening in the yen is doing more to raise food and energy prices than it is boosting exports, as Tokyo had hoped.
All of this is causing the tide of global liquidity to recede, leaving vulnerable countries like Turkey, Argentina and South Africa barren in a repeat of the dynamics that fueled the 1997 Asian financial crisis.
In other words, the panic selling by investors may not be over. Three negative catalysts loom: a default in China, deepening currency volatility and another potential battle in Washington over the debt ceiling.
China is officially shut down between now and February 6 for Chinese New Year celebrations. But when everyone returns, we're sure to see the next phase of China's credit crunch play out.
Although the $500 million "Credit Equals Gold #1" trust was bailed out, this was just tip of the proverbial iceberg that is China's swollen and unsustainable dependence on credit. More default risk is likely as high-yield loans become larger and larger burdens for Chinese companies suffering from pinched profitability as the economy slows, idled factory capacity grows and prices drift lower. Capital Economics notes that the growth in seaport cargo traffic has collapsed from a 15 percent annual rate in mid-2013 to less than five percent now.
This will be a shock to the system since Chinese authorities have made a habit of bailing out investors at the last minute, reinforcing "moral hazard" and lulling people into a false sense of security. Nearly two dozen trust companies in China needed rescue in 2013. But with Beijing aware of the growing risks of inaction, and with a stated desire to liberalize and reform the country's financial system, a bout of short-term pain is likely in the months to come.
While the emerging market currency situation seems to be calming a little over the last 24 hours, it's far from over. We're even seeing volatility hit Russia, where the ruble has actually fallen more year-to-date than the Turkish lira has. It wasn't until the Asian contagion hit Russia in 1998 that people really started panicking, leading the Fed to cut interest rates and ignite the terminal phase of the tech bubble. History repeating itself, perhaps?
And finally, the U.S. Treasury estimates we'll hit the debt ceiling on February 7 (although the government can likely push the deadline to the end of the month through budgetary maneuvering). Bond market volatility and the potential for another credit rating downgrade loom as the consequences of inaction.
The political posturing has already started, with Democrats
demanding a "clean
increase" while Republicans want policy concession in exchange for an
increased borrowing authorization that will take the national debt to $18
trillion and beyond. Exactly what form those concessions will take will come
out of a strategy meeting Republicans are currently holding.
Add it all up, and I think caution is still warranted here with a focus on defensive assets like Treasury bonds (which, confusingly, tend to do well during debt-ceiling showdowns) and non-cyclical stocks in areas like utilities, such as Exelon (EXC), Entergy (ETR) and Duke Energy (DUK). My position in the leveraged Direxion 3x Treasury Bond Bull (TMF) is up more than 9 percent since I added it to my Edge Letter Sample Portfolio on 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.