Stocks Remain Vulnerable To More Weakness

by: Chris Ciovacco

Italian Elections

An extended U.S. stock market was handed some bad European news Monday. From MarketWatch:

Hopes for a clear-cut outcome in Italy's parliamentary elections on Monday gave way to fears that a strong showing by Silvio Berlusconi and his center-right allies could trigger a fresh round of political instability.

It is possible another round of elections will be required. Another round of elections means more uncertainty. Financial markets do not like uncertainty.

Last Week, Charts Said "Be Careful"

While today's weakness in stocks will be attributed to the elections in Italy, stocks have been shooting up warning flares for over three weeks. One example is the ratio of small-cap growth (NYSEARCA:IWO) to Treasuries (NYSEARCA:TLT) (chart below). When the ratio rises, small-cap growth stocks are in greater demand than Treasuries (a.k.a. risk-on). Conversely, when the ratio falls, Treasuries are in greater demand than small-cap growth stocks (a.k.a. risk-off). Last time the ratio reached the top of the blue trend channel (point A), stocks corrected for several weeks (point B). The ratio is turning down again near point C. If the pattern holds, the ratio could "fill the white space" as the S&P 500 corrects further.

The February 23 video below covers numerous areas of the market that were saying "be careful" as of the close last Friday. The video covers the following ETFs: Russia (NYSEARCA:RSX) at the 4:42 mark, copper (NYSEARCA:JJC) 7:25, coal stocks (NYSEARCA:KOL) 9:26, materials (NYSEARCA:IYM) 10:06, U.S. dollar (NYSEARCA:UUP) 11:26, utilities (NYSEARCA:XLU) 13:17, shorts (NYSEARCA:RWM) 15:11, and small-cap growth 16:17.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.


Unlimited QE May Not Be Unlimited

While it is unlikely the Fed's easy money policies will be altered anytime soon, the release of the last Fed minutes showed how easily markets can be spooked. It is not in the Fed's best interest to have a mass exodus from U.S. Treasuries since it puts upward pressure on interest rates. Consequently, a little jawboning to pull some of the froth out of stocks and put a bid under Treasuries is part of their game plan. The Fed will not begin unwinding their massive balance sheet in the coming months, but a little fear regarding that topic isn't such a bad thing for Mr. Bernanke and his friends.

Sequester Becoming All Too Real

Regardless of your stance on government spending and economic growth, there is no question that when the government spends less, it hurts GDP in the short-run. The impending budget cuts will have a negative impact over the coming quarters. With a massive bid under Treasuries Monday, the markets may be coming to grips with the short-term ramifications of the soon to be made spending cuts.

Remaining Defensive

We took profits and raised cash back on January 24, citing a poor risk-reward ratio for investors (see tweet below). The day we booked gains, the S&P 500 closed at 1,494. We have missed nothing. Monday, the S&P 500 "gave back" all the gains posted over the past four weeks, closing at 1,487 (below 1/24/13 level).

We will continue to monitor the markets with an open mind. If we see improvement similar to what we cited back on November 19, 2012, we are willing to redeploy some of our cash. For now, we are happy to remain patient looking for a better risk-reward pitch to hit. That pitch could come somewhere in the neighborhood of 1,472 (see chart below), or it may not come for several weeks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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