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Stock selloff continues on Europe, weak U.S. consumer

Updated at 4:20 p.m. ET

Stocks tumbled again on Thursday, with the S&P 500 testing below its 50-day moving average and the Russell 2000 small-cap index setting new correction lows, as investors run for the exit just days after large-cap stocks set new all-time highs.

The Dow Jones industrial average lost 16 points, closing at 16, 647, to lead the decline, while the Standard & Poor's 500 and Nasdaq composite index also slipped. The Russell 2000 fell 7 points to end at 1,096.

The dichotomy in the market has been striking. Large caps having been holding up relatively well. Small caps have been wilting. And the Treasury bond market is rallying, pushing down yields in a clear warning that the fixed income market is worried about something.

Moreover, the evidence suggests that, at least for small caps, the correction is only about half way done.

There were two main catalysts for Thursday's drop.


Walmart (WMT) reported weaker-than-expected quarterly results, with same-store sales traffic declining and the impact of winter weather not enough to justify the miss to the bottom line. This adds credence to the idea that the U.S. consumer is under pressure given Tuesday's disappointing retail sales report. Shoppers are being beleaguered by higher inflation on food and shelter amid ho-hum earnings growth.

The other was the worst selloff in the eurozone bond market in 15 months on a weak GDP report and a drop in forward inflation expectations. European stocks were also hit as the FTSE-100 index lost 3.5 percent while Portugal's market lost 2.8 percent. Also contributing was chatter that Greece was considering retroactively taxing certain bond sales this year, which shattered sentiment despite Athens fervent denials such an idea was being considered.

This is having such a large impact on the U.S. stock market because of the popularity of the so-called "yen carry trade," whereby hedge funds and other institutional traders would sell the Japanese yen short and use the proceeds to buy stocks and bonds denominated in euros or dollars. This is why eurozone bond prices have been rising so powerfully since late 2012, pushing down eurozone borrowing costs and quelling the regions debt crisis.

The trade got crowded. Even Greece, which still faces economic reform hurdles amid a catastrophically high 26.5 percent unemployment rate, returned to the bond market last month by selling three billion euros worth of five-year bonds with a yield of just 4.95 percent. That may very well have marked the top of the rally for eurozone bonds.

As a result of the weakness, the Japanese yen is poised to break above the trading range that it has held since the beginning of the year -- and thus, challenge its 200-day moving average for the first time since 2012. That will hit yen carry positions hard, with the consequences rippling through the global financial markets.

Greek bonds aside, the U.S. stock market was suffering from some overvaluation as well. According to Credit Suisse, the price-to-sales multiple on the Russell 2000 rose to just below its all-time high set in the late 1990s earlier this month. They estimate small cap stocks have another eight percent of downside.

The big question is: How long can the large cap stocks trade near record highs, resisting the negative impact of the reversal of the yen carry trade and the persistent weakness of small caps?

Not likely for long, which is why I've been recommending clients move into defensive assets including the leveraged Direxion 3x Treasury Bond Bull (TMF), which I just closed for a 22 percent profit in my Edge Letter Sample Portfolio. My latest addition is the VelocityShares 2x VIX (TVIX), a leveraged play on the CBOE Volatility Index or "fear gauge" that rises when stocks are falling.

Disclosure: Anthony has recommended TVIX to his clients.

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