Why Markets Won't Fall by More Than 10%

Includes: DBV, DFE, EMB, EWX, JNK, PCY
by: Daily Trading

Over the last 18 months, our view has consistently been that any weakness should indeed be viewed as a buying opportunity. But, are things different this time? Do we think that the market may fall by more than 10%, and should we increase our shorts?

We will be staying long, and here is our reasoning behind this decision:

Prior to an important top in the equity market, there is usually a prolonged period of weakness in equity market internals and also risky assets of each asset class. By this we mean emerging market bonds, junk grade corporate bonds, emerging market currencies, and high yield currencies relative to low yield. By prolonged we mean a period of time that suggests something more than short term market noise/panic is at play. This period is generally a period of about 3 months (let us not be too clinical about that).

We are trying to identify whether or not there is a change in mood or sentiment within the market.

I am quite sure that by now we have all seen some weakness creeping into emerging market bonds, but this weakness is only a couple of weeks old. In fact, emerging market bonds have been surprisingly resilient to the PIIGS storm. Our yardstick of measure would be to see a fall below the February lows, which is still quite a ways away.

The lack of any bearish activity in high yield corporate bonds has been quite interesting for those so inclined. Junk bonds do not look like they are being sold off rapidly and heavily.

Some angry bears have raised their head yet again over the last few weeks. Once again, the markets have refused to listen. Small caps are still trading withing their normal trading range.

Let's look at the very bullish looking NYSE Advance Decline line.

On Monday, the ETF DBV (a proxy for the carry trade) traded at a multi-week high, seemingly unphased by the drama playing out in Europe.

We have found that the carry trade usually turns down well before equity markets. Yes, it did close lower last night but for the time being that amounts to nothing more than noise. Until we see DBV close below the 23 level our view remains bullish.

We don't know what the future holds, but we do know that once an investment theme takes hold, it generally lasts for months at a time.

So, until proven otherwise, one has to trade with this trend. There is little credible evidence that the risk seeking (call it what you will) theme that has driven equity markets higher over the course of the last 12 months or so is in trouble.

We cannot see the "smart" money running. At this stage it is just the weak hands that are running for cover. Oh, and it also helps that the reason for the weakness appears to be unrelated to company fundamentals with companies continuing to come in with earnings surprises.

A sell-off based on a string of profit warnings is one thing, but a sell-off due to panic over a minor country's debt is something else. The odd bit of profit taking may indeed be occurring, but that is not such a bad thing.

Disclosure: Author long JNK, DBV and GWX

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