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It is clear from nearly all asset classes, that there is a lot of fear in financial markets at the moment. The classes I am referring to are:

  • Stocks
  • Commodities
  • Bonds
  • Currencies

I would suggest this is for 3 main reasons:

1. The European situation: If Greece leaves the Euro, there is the chance of a substantial fall in the price of stocks and commodities and currency pairs would move substantially as well.

2. The slowing world economy: Chinese, European and American data have all come in weaker than expected. The European union is already in recession and the ECRI have called for a recession in the U.S.A.. China's growth is clearly slowing.

3. The history of the bull market from the lows in 2009: The summers of 2010 and 2011 have both given us substantial corrections. The markets fear that 2012 will be the same and are positioning themselves away from risk assets, in case we repeat the pattern this year.

It is clear that there is plenty to worry about. This worry is not the only problem. Central bank intervention in the form of the Fed and BOE monetization and the fact that large swaths of the western world's sovereign debt is no longer perceived as safe, is reducing the stock of safe assets. I am presently at a loss to find assets that I think are totally safe. Gold, Norwegian, Canadian and Swedish bonds, along with some corporate bonds are as good as it gets. However the market is still going back to the old favorites of Treasuries and Bunds.

I have been looking at the daily charts of the AUD/USD, EUR/USD and GBP/USD. Each one is technically oversold and there are bearish divergences (for the dollar in every case) in the RSI and MACD. It is unusual for all currency pairs to be in this position. I would add that the weekly charts of the currency pairs are not as extreme, which suggests that any move will not mark a change in direction for the dollar. Any move will likely be a correction to the present trend.

Fundamentally, the dollar has been strengthening on the grounds that it is the least bad of a very bad bunch. The Yen strengthening runs counter to that argument. The Japanese have started to move into trade deficits and the economy is still moribund. On the least bad argument, it is difficult to see why the yen should be strengthening. There must be another reason. There is clearly a shift into the perceived safe currencies. For the life of me, I cannot understand why the U.S. dollar and the yen are perceived as safe. Safe would be the Canadian dollar, the Norwegian Krone and the Swiss Franc. However, the market judgment is that the U.S. dollar and the yen are 'safe'.

Looking at the position of stocks, the S&P 500 daily chart is not oversold, but there are bullish divergences for RSI and MACD. Markets across Europe are oversold. It is clear that the world economy is slowing and the markets around the world are starting to reflect this. But again, the U.S. market has held up better than the rest of the world. The U.S. has a present budget deficit of 8% of GDP and is still only growing in the 1.5-2% area. The only long term reason that this should be the best performing market in the world is if fear is ruling investor's decision making process.

Of the commodities, oil, copper, silver and gold are showing bullish divergences on their daily charts. Silver and gold are not technically oversold, but oil and copper are. Copper is referred to as Dr. Copper, as it is a sign of the health of the world economy. The fact that both copper and oil are in a serious decline is definitely a warning sign that all is not well. The alternative explanation is that there is panic in the air and all perceived risk assets are being sold.

The daily charts of the US 10-year treasury and the German Bund are both overbought and showing bearish divergences on RSI and MACD. These patterns are also showing on the weekly charts, which reinforces their message. As I am sure you are aware, bonds are a safe haven and are highlighting the present 'risk off' environment. As such, their charts should be the inverse of the 'risk on' asset classes. The 10 year Bund has a yield today of 1.18% and the 10 year Treasury is at 1.5%. There is definitely fear reflected in these yields. The question would be are these yields temporary or are they signaling the start of a period that mirrors the Japanese experience.

This present situation is unusual. To have nearly all risk asset classes showing very similar chart patterns is not something that I remember seeing before. It doesn't mean it has not happened before, just that I don't remember it.

The question is, what to make of it? There are 2 possible explanations:

  1. When bull or bear markets get going, the technical position often gets stretched. It is often a sign that a new trend is developing. If this is correct, the stretched positions shown on daily charts are indicating the beginning of a substantial correction in risk assets.
  2. The alternative is that the previous trend got overdone and the reverse reaction is greater than would be normal. This would suggest that the correction is just a mirror reflection of the advance. The advance was stretched and the correction is the same. If this is the case, the bull market will resume at some stage soon.

It is clear that the over 30% improvement in the S&P 500 since October 2011 is extreme, but the commodities and currencies did not match this performance. Now all 'risk on' asset classes are correcting hard. It is still too early to say for sure, but if we don't get a substantial 'risk on' bounce soon, we will be in for a difficult summer. With everything that is going on at present, there will be plenty of excuses for the markets to rally. It may be the Greek election results, Chinese stimulus or U.S. data. If the market does not rally on any of these stories, I would advise caution. This will be the market's way of telling you that all is not well. Personally, I am waiting for the Greek election results before making any substantial investments. I think that these will be crucial for the short term direction of the market. I also feel that these are the most likely catalyst for a bounce in risk assets. The elections are over 3 weeks away, but will the markets tread water until they are over, due to their importance? There is definitely fear in the air and it is possible that the markets just continue to fall as the European story is not the only worry. It may be that the markets are more worried about the global slowdown than they are about Greece.

The question for investors is -- Is this fear justified or not? If it is, you should be selling. If it is not, you should be buying.

Conclusion

The technical position in all the asset classes discussed suggest a bounce in risk assets. As discussed above, this stretched position may just carry on and risk will continue to be sold. I am waiting for a rally, so that I can add to my present short position. I am not looking to buy the dip. I have felt that there is one more large fall to come in markets before this crisis is over. This is the way that I feel every time markets start to sell off. This is generally just before the central banks unload their next intervention on the markets and I get burned. What I am waiting for, is the time when this intervention is not successful. I have argued many times that QE is weak monetary policy when short term interest rates are at the zero bound. QE has done little for the real economy, which is why we need constant refreshers. I am doing the unthinkable, I am fighting the Fed. So far it has not proved successful, but the Fat Lady has not sung yet.

Source: Fear Starts To Drive The Market

Additional disclosure: Long RWM, RIMM, USD/JPY, various U.K. corporate bonds