The political situation in Europe is weighing on market sentiment again on Wednesday, pushing stocks down through major technical support levels. Everywhere you look, it's looking ugly. The bulls are doing their best to trim the losses, but it's increasingly apparent they're trying to hold back a rising tide.
Eventually, the selling pressure that's welling up is going to wash them away as Greece heads for new elections, the European Union starts withholding Greek bailout payments, and the International Monetary Fund is scaling back its exposure to the eurozone debt crisis -- all within the context of a new eurozone recession and new worries over the health of Spain's banks. Here's why.
As the chart above shows, the situation remains extremely vulnerable. The small cap stocks in the Russell 2000 continue to dangle a leg over the edge of the abyss by falling -- for the second day in a row -- towards the 780 level before late session buying pushed the index back over its four-month support line. With momentum waning, and a head-and-shoulders reversal pattern forming, a breakdown looks likely.
There are plenty of catalysts for this that are continuing to develop. In other words, the situation is going to get worse before it gets better (via central bank intervention, no doubt). But not everyone can follow the intricacies of Greek parliamentary politics or Spanish banking regulations.
To keep it simple as the market moves lower, keep your eye on these four areas to keep track of how bad things are:
Currencies
The euro-dollar exchange rate (/EURUS) is closely followed since hedge fund types have been busy selling dollars and using the proceeds to fund speculations in dollar-sensitive "risk on" assets like commodities and foreign stocks. The euro/dollar rate also acts as a sentiment gauge for the ongoing debt woes in Europe. When it drops, other negative effects follow: European stock losses, higher sovereign borrowing costs, and trouble for Europe's financial system.
All of these things are happening now as the euro falls through the closely watched $1.30 dollar-per-euro level -- a level that's been rarely breached since 2006, with the most significant excursion happening during the initial Greek bailout scare in 2010. The euro closed at $1.295 today. As long as it's falling, "risk on" assets like stocks will move lower.
Commodities
Related to this is the massive drop underway in commodities, particularly industrial commodities like crude oil and copper as traders slash their economic growth forecasts. Lower growth equals less need for the raw inputs of production like fuels and metals.
Until the DB Commodities Tracking Fund (DBC) -- which is already down 34% from its March high -- stabilizes and moves higher, we won't be out of the woods. The silver lining in all this is that falling raw materials will ease inflationary pressures, pulling down gas prices and offering some relief to beleaguered consumers. Already, crude oil is back to November/December levels.
"Junk" bonds
One of the market's strongest "tells" is the performance of high-yield bonds -- which act as a middle ground between sober Treasury and corporate bonds and high-risk equities. Since the bull market started in early 2009, the end of every major pullback was associated with the iShares High Yield Corporate Bond ETF (HYG) dropping hard into deeply oversold territory -- represented by a downward violation of its lower Bollinger Band.
We haven't seen that yet as the HYG is still hovering near its three-month highs. Either the relationship has changed, the credit markets know something every other market doesn't, or sentiment hasn't yet been sufficiently damaged. I believe it's the latter.
Cyclical stocks
And finally, the recent market declines have been led by cyclical, economically-sensitive emerging market, semiconductor, energy, and materials stocks. Small caps have also underperformed.
These are tangible signs investors are becoming gloomier about the future and are flocking for the relative safety of larger, non-cyclical defensive issues like telecoms AT&T (T) and Verizon (VZ) while shunning the likes of Ford (F) and Caterpillar (CAT).
Again, until this relationship changes, look out below.
***Trading update
I am adding one new materials short to my Edge Letter Sample Portfolio, Mexican cement giant Cemex (CX). Highlights of exisiting holdings include 10%+ gains in Gerdau USA (GGB) short and Direxion 3x Semiconductor Bear (SOXS) long.
Disclosure: Anthony has recommended CX short to his newsletter subscribers.
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