A deep correction's on the horizon; how prepared are you?
• China PMI falls for fourth consecutive month
• ECB shows little sign of action on inflation
• Ukraine crisis still a major factor
Monday’s fall in European stock markets means the week has started on a sour note. The most important bad news came from China, where Markit reported that the manufacturing purchasing manager’s index (PMI) had shown contraction for the fourth month in a row (see press release: Business conditions continue to deteriorate in April). That dropped the AUDJPY spot below its recent range, and after recovering to pre-PMI levels, the latest Sentix investor confidence was published and being clearly below consensus forecast, the markets turned down again. The historical relationship between the Sentix and stock market is illustrated by Mads Koefoed’s graph.
In addition, it seems
that traders expect that the European Central
Bank (ECB) will fail to do anything at Thursday’s policy-setting meeting. The central bank is waiting for the new ECB staff inflation forecasts to be published, pushing the earliest date of monetary policy changes to June. As the European Commission today published its spring 2014 economic
forecasts, which revised the 2014 inflation forecast down from 1.0 to 0.8
percent and the 2015 forecast from 1.3 percent to 1.2 percent, the ECB's reluctance to act just shows how empty its toolbox really is.
The crisis in Ukraine is also not showing any signs of going away quickly, which means uncertainty will continue, investments will be postponed and the economic sanctions will be seen to dent growth. Is this just a bad start to the week, or a sign of darker times ahead? I think the stars are aligning to suggest an increased risk of a market correction in the coming months.
The arguments for a deeper correction are piling up
Two estimable commentators are seeing trouble ahead for the stock markets. Their main arguments are based on sentiment, market breadth, bond markets, stretched valuation, seasonals, and relative sector performance.
Cam Hui posted on his blog with the headline The bearish verdict from market cycle analysis, where he looked at the different sectors of the stock market, and noted that the relative performance of the sectors suggests an increased risk of a correction ahead. He has previously written about the deteriorating market internals, seasonality and the underappreciated macro risks caused by China and the Ukrainian crisis.
Urban Carmel’s Weekly
Market Summary notes that the market breadth divergence and negative
seasonal effects are happening simultaneously, putting the market in a similar
situation as in July 2011 or April 2012. The period from May to October tends
to exhibit flat returns, and during the past 10 years there has been a notable
market correction in every year except one.
Sell in May and go away?
For the time-constrained, one chart tells the story. For the past 20 years, an investor who has been long the S&P 500 only during the periods from May to September, has earned flat returns. All the stock market gains have happened during the periods from October to April.
While the May-September periods have not, on average, exhibited negative price changes, the markets have often gone through deep corrections. This has made the risk-reward ratio for holding stocks negative, especially for the weak hands that might not be able to remain invested during a deeper correction.
Wesley L. Gray recently ran a test with different asset classes, including bonds and factors such as value and momentum. The results confirmed the May-October effect for most assets, and concluded that the effect is especially strong for stocks. The tendency of other factors to exhibit the same pattern as stocks is not that surprising, if one remembers that during times of flat returns or market corrections many institutional investors have had to lighten up their positions. This tendency is one of the reasons why cross-asset correlations tend to increase during market routs. For more on the "Sell in May", see Lance Roberts.
AUDJPY thermometer somewhat negative
In my article last week, Why AUDJPY is the Swiss army knife for traders I wrote about the strong relationship between the AUDJPY crossrate and the equity markets. On February 3, all three markets turned higher together but after the next low on March 14, the stock markets failed to convincingly follow the AUDJPY’s surge to new highs. While the DAX-index move higher was relatively large, it failed to make new highs, and the whole move higher could be seen as a reaction to the previous slump caused by the Ukrainian crisis. Ukraine-related headlines weigh more on the German market than the US.
The downward-sloping trendline in DAX since the January’s highs has held, and the market has lost momentum. The S&P 500 has been essentially range-trading since early March. At the same time, AUDJPY has broken below mid-April’s trading range, and looks as if it could be ready to break below its recent trading range as well.
For the moment, it
looks as if the resistance level in DAX will hold and cap the markets,
especially if the AUDJPY does not begin to exhibit signs of strength. The next
five months could very well see volatile and flat equity markets, including a
nasty correction of roughly 10 percent. With Europe’s crisis countries enjoying
exceptionally low bond yields and many betting on the ECB to save the day, I believe it is very important to
adjust one’s investments to be able to tolerate a larger correction.
See also Teis Knuthsen’s excellent Investment Outlook: Stocks on the rise but only just.
Source: Saxo Trader
Source: Saxo Trader
Helsinki-based Juhani Huopainen blogs at MoreLiver's Daily. His specialities include options (also exotic), the euro crisis and EURUSD.