The tone of the financial markets went from somber to just plain ugly last week, as investors began to cut risk positions in earnest. What seemed like an orderly retreat earlier in May began to look like across the board liquidation, leaving many of us to ask, what now? Let's break down the numbers:
Stocks: The selling that hit the equity markets from the start of May accelerated last week. The Nasdaq Composite and Russell 2000 dropped more than 5%, the S&P over 4%, and the Dow Industrials 3.5%. The Russell and NYSE Composite both fell below with 200 day moving averages; the NYSE is now negative year to date. The markets sold down each day last week, closing at or near the low of the day, with volume increasing as the relentless liquidation of shares continued.
Unsurprisingly, all nine major S&P sectors were off for the week, and the tone was very defensive. Only the utilities and consumer staples lost less than 2%, while the financials dropped a whopping 7%, no doubt in large part due to the difficulties of JPMorgan Chase (JPM), which has shed more than 20% in the two weeks since the revelation of its multibillion dollar trading losses. Even the much anticipated Facebook (FB) IPO was unable to lead any kind of rally. Market bellwether Apple (AAPL) has also been unable to stem the red tide, the shares having dropped more than $100 over the last six weeks.
All twelve foreign equity indexes we monitor posted losses, many of them quite heavy. Russia's RTS Index was off more than 11%, Brazil's Bovespa over 8%, South Korea's Seoul Composite 7%. Around the globe, there were few places to hide from the carnage.
Bonds: The bond market portrayed the deep risk aversion very starkly last week. Treasury yields plunged at the long end of the curve, while yields on corporate bonds, both investment grade and below, spiked. Yields on bank preferred equity - a fixed income-like instrument - shot up for the second week in a row, portraying investor nervousness about the potential impact of an uncontained European meltdown. The municipal bond market, on the other hand, was relatively calm.
Commodities: The prolonged slump in commodity prices broke last week, even though crude fell to another new low for the year. West Texas Intermediate decisively broke the 200 day moving average and fell through the December support level of $92.50. Ever contrarian natural gas, on the other hand, extended its rally into a fourth week. It was joined by the grains, which also broke higher - in the case of wheat, dramatically higher. Gold re-tested the $1,525 level, which was the December bottom, and bounced back toward $1,600 in the latter part of the week, perhaps benefiting from the flight to safety trade.
Currencies: The U.S. dollar index continued to rally into the January highs above 81, and stalled there, while the fading euro found near term support at $1.27 and the Swiss Franc found a bid at $1.06. The British Pound saw its steepest losses of the year, breaking the 200 day MA and closing in the $1.582 area. The Australian and Canadian dollars were also off sharply against the greenback. Yen, another safe haven, resumed its advance higher.
Last week's U.S. economic calendar was a mixed bag, but it was overshadowed by the ongoing crisis in Europe. Unemployment claims once again were slightly higher than expected, and the Philly Fed and April leading indicators surprised with a negative print. On the positive side, housing starts showed more evidence that the housing market is at least stabilizing, if not growing at a robust pace. Fed Chairman Bernanke seemed to spook the already skittish markets by warning senators that the economy faces a "fiscal cliff" in the form of potential budget cuts and expiring tax breaks. However it was Europe that continued to remain in focus; reports that officials were actually preparing for a Greek exit from the EMU fanned fears of a wider financial meltdown.
Stocks: While there is a perceptible sense of fear in this market, tuning out the noise and turning to rational analysis can help us to find our way through this. To me the May trading action still looks more like a counter-trend reaction to the October to April rally, than the start of a major bear market. As of Friday's close, the SPX had done a 38% retracement of the entire move from the October 4th bottom to the April 2nd top, and had come back to the top of the October rally. Several sectors have fared worse, and are in negative territory for the year to date. In the short term the market is severely oversold. We have now seen a run of 13 days in which 11 were down, and the two up days were only slightly higher than the previous close. The McClellan Oscillator for the NYSE stands below -110, an extreme reading.
Where do we go from here? In the coming days it is not unreasonable to expect a bounce from oversold conditions. Look for the SPX to take a run at the 1,340 - 1,350 area. I would use that as an opportunity to cut back trading positions that aren't working and raise cash. We should pay attention to daily trading patterns and - yes - volumes. This recent drop has displayed the classic bearish pattern of starting higher in the morning and selling heavily into the close. A test of the 200 day, currently ~1,280 on the SPX, is very likely. If it doesn't hold, then we could see 1,200 in short order - a 62% retracement of the move off the October low. In any event, this is not a time for panic or for heroic action. We were not fully invested to begin with, have recently raised a little more cash, and are now watching from the sidelines. Danger today, opportunity tomorrow.
Bonds: We have seen this movie before. Sometimes it seems the whole world hates U.S. Treasury bonds, but at the first sign of real trouble, Treasuries are where many investors turn for safety. The result is that we have yields on the long bond approaching the October low under 2.8%. The Treasury market is pricing in a disaster scenario. The good news here is that corporate bonds, which have been caught up in the liquidation, are coming back into levels where the yields are more attractive. We've been looking for better opportunities to put money to work in our income portfolio, so now it's a matter of waiting for things to settle down. Income investors should stay alert, the market is about to hand us a nice gift.
Commodities: The action in commodities has gotten interesting. Since the rally off the October bottom, they corrected more deeply in December, rose less vigorously in Q1, and rolled over earlier than equities. Last week they seemed to be putting in a short term bottom, perhaps on the expectation of more QE at home and something like QE abroad. Certainly Chinese policy makers are trying to do their part with easing of reserve requirements. At the same time we saw the rally in the U.S. dollar stall. This is a divergence worth watching, and perhaps gives us a clue about what to expect in terms of the outlook for the equity markets. It's too early to make much of it just yet, but certainly bears watching carefully.
Currencies: The dollar has put in a powerful rally that has coincided with the May sell-off. By mid-week the rally in the dollar index seemed to have stalled at the January highs. While commodities took advantage of the respite and caught a small bid, equities continued to sell right through the move. At this point the dollar is at the top of a trading range. In previous moves it has backed off from the 80 - 82 area on the index. We'll see what happens this time. Of course much depends on the European situation. The G8 meet at Camp David this week, and while a number of global issues are on the agenda, the deteriorating economic situation in the European periphery is sure to garner much attention. My expectation is that any indication of something other than utter policy incompetence on the part of the European leadership - yes, a tall order to be sure - could reverse the current trend in the markets. It might only be temporary, but we'll take it.