Risk appetite faced near destruction last week, with global equities and commodities valuations suffering their worst losses in recent memory. Including Friday’s “rally” – which was more of a panicked scramble to cover shorts in the final 20 minutes of weekly trading – the Dow and S&P 500 each declined over 4 percent while the tech-heavy Nasdaq slid over 5 percent.
On Thursday, the two-week anniversary of the May 6 intraday crash, investors were offered a glimpse of the troubles that lay ahead. With global markets sliding violently and (institutional) investors shunning risk like the plague, the euro enjoyed one of its best performances in history – climbing nearly 10 percent against the Australian dollar in less than 24-hours.
While a more organized selloff than its May 6 predecessor, Thursday’s price action represented a far more troubling phenomenon: the global disengagement from risk. Meanwhile, the scope of “riskier assets” was greatly extended, as evidenced by dislocation in the credit markets. In addition to growing strains in interbank and bank-to-consumer lending, corporate debt purchases plummeted by 67 percent last week, with investment grade bonds being treated like mortgage-backed securities. (Several warning signs in the credit markets and elsewhere over the past several weeks culminated in this May 5 warning: “Significant Correction, Reversal Looming.”)
Looking ahead, investors should prepare for further, significant pressure on riskier assets. Downward trending markets, though punctuated by intermittent short-covering rallies, will see the Dow below the 10,000 mark for an extended period. The credit markets, meanwhile, will largely dictate the magnitude of the impending declines. Indeed, further weakness in lending, debt issuance and global debt-demand promises a global double-dip scenario, from which the recovery of confidence alone will be next to impossible.
Securities of Interest
USD, JPY, Safe Havens
Analysis and Trade Ideas
Safe haven securities – such as the US dollar, Japanese yen and Treasuries – should greatly outperform their riskier counterparts in the weeks ahead. A fade- the-rally-approach to the markets is highly advisable and investors should carefully monitor the credit markets for additional clues as to the duration and severity of coming declines.
As sentiment turns increasingly negative, worrisome trends in housing and unemployment, which investors have largely ignored over the past 14 months, will begin to have an exaggerated effect on the markets.
Last Wednesday, the Mortgage Bankers Association released troubling, though predictable, data indicating that new mortgage applications plummeted to their lowest level in 13 years while the share of US mortgages in foreclosure reached a new record.
Mortgage applications declined 27.1 percent week-over-week and coincided with the expiration of the homebuyer tax credit on April 30. The data indicate that the “bottom” in housing, much like that of the broader economy, was a function of government incentive and spending, rather than legitimate consumer- and corporate-side demand.
Unemployment in the U.S., meanwhile, has yet to show signs of substantive improvement and may, in fact, grow worse in the months ahead. The unemployment rate ticked up to 9.9 percent in April, from 9.7 percent in March, which has been dismissed by analysts as being the result of jobseekers reentering the labor force. (I’m reminded of the old adage: “You can put lipstick on a pig…”).
In the week ending May 15, initial jobless claims rose by 25,000 to 471,000, making the upcoming data release this Thursday that much more important.
Until clarity is restored to the capital markets (and the global economy in general), retail investors should short risk alongside their institutional counterparts. At the very least, downside protection should be employed immediately, be it through a balanced long-short portfolio or through the purchase of puts on equity indexes.
Forex traders need only stick to recent trends in the marketplace, which strongly favors further upside for the US dollar and Japanese yen across the board.
Disclosure: Author is Long EEM Puts and Short USD/JPY