We were looking for a possible correction in early 2014 due to growing investor optimism in late 2013. That correction may now be underway, but thus far, a decline of about 5 percent in the S&P 500 Index constitutes a bump in the bullish road. That said, the situation in emerging markets has deteriorated, and that has the potential to shake up the global economy should China join the rest and weaken substantially.
Odds are still long for a resumption of the bear market, but there are risks on the horizon that could slow the recoveries in Europe and the United States. The bull market is already 5 years old, which puts it above average in terms of length. Going solely by market history, a substantial correction would not be a surprise.
In sum, investors need to pay close attention to the support levels of major indexes, currencies and emerging markets, along with important momentum leading sectors.
These are several ETFs you may want to follow closely:
SPDR S&P 500 Index (SPY)
First, pay attention to SPDR S&P 500 Index (SPY). The downside target for a small correction is $169 on SPY, just below the current 200-day moving average. This would mark a drop of roughly 9 percent from the high, a solid pullback in shares, but still not a major correction of the bull advance.
iShares Russell 2000 (IWM)
Another major index ETF to watch is the iShares Russell 2000 (IWM). The Russell 2000 is down 6.6 percent from its peak on January 22, a drop greater than that of the S&P 500 Index, which is down 5 percent from its peak. Thanks to a stronger start in 2014 though, it was only in the past two trading days that the return on the Russell 2000 dropped below that of the S&P 500 Index. This is important because as long as small caps were holding up better, it was a sign of strength for the bulls. Small caps are more volatile and usually lead on the upside during bull markets and to the downside in bear markets.
CurrencyShares Japanese Yen Trust (FXY)
The Japanese yen has rallied during the current global slide in equities. It was the go to bear market asset in 2008 because many traders were short the yen and long other assets. After the Japanese government pushed for more stimulus in late 2012 and central bank fired up the printing presses in 2013, it once more attracted large numbers of short sellers, who went long the Japanese stock market as the other side of the trade. With global assets selling off again, traders are reversing their yen short/Nikkei long trades.
The dollar/yen cross is important to watch because both bulls and bears expect the yen to drop in value. The bulls are looking for a Japanese economic recovery in the wake of a weaker yen, while the bears are looking for a bond crisis that leads to a collapse in the yen (or vice versa). Furthermore, both these moves are predicated on the idea that central banks printing money can cause inflation. If Japan fails again, it will send a shudder across Europe and the United States, since it will suggest the central bankers have only delayed the crisis that began in 2008, not ended it.
iPath S&P 500 VIX Short-Term Futures ETN (VXX)
One of the worst ETFs to own since 2009 is iPath S&P 500 VIX Short-Term Futures ETN (VXX). The fund tracks futures contracts tied to the VIX index, which measures implied volatility in the market based on options prices. This index doesn’t signal actual volatility, but expected volatility. It peaks with fear and declines on optimism. A spike in the level is often bullish because traders and investors are often late: they get fearful after the market has dropped. The recent spike in the index could signal the end of the current decline. Investors should watch VXX and the VIX itself to see if the one-day reversal on Tuesday will continue in the coming days.
iShares NASDAQ biotechnology (IBB) & Market Vectors Solar (KWT)
Both biotechnology and solar have been two market leading sectors. Both of these ETFs have dipped in price, but their charts are still bullish. Based on the charts, a bullish interpretation of the current correction is warranted: shares in two of the hottest sectors of 2013 have failed to break. Were they to take out prior lows though – below $67 in the case of KWT and below $213 in the case of IBB – it would be a bearish sign. Both shares would need to fall more than 10 percent to break those levels.
While there is risk of a greater decline in stocks, for now the pictures indicate the decline may max out around 10 percent for the U.S. markets. Given that the U.S. dollar has been strong, U.S. stocks will continue to outperform to the downside as currency losses add to the declines in Europe and emerging markets. The greatest risk comes from emerging markets, where economic factors are also in play, in contrast with the U.S. where the decline remains confined to the stock market and some volatile sectors remain in bullish patterns.
For now, weakness in emerging markets is bullish for the U.S. dollar and U.S. Treasuries. Lower interest rates and lower commodity prices help the U.S. economy, though stocks will drop in sympathy if there’s a major emerging markets crisis. Emerging markets are a far larger part of the global economy than they were in 1997 and this means the pain from another crisis will also be greater. Many U.S. multinationals derive substantial growth from emerging markets and these firms could under perform. Investors worried about emerging markets need to consider their exposure to multinationals.
And to reiterate, while we take a cautious view of the current slide, at this point it remains a small bump in the road for U.S. stocks. Investors nervous about a larger decline can sell the bounces, but remember that whatever looks good right now, such as the utilities sector that is up 1.45 percent in 2014, will very likely underperform when the markets eventually reverse.