Italian Voting Deadlock and Sequestration Worries Cause a Market Selloff

The comments made in last week’s column about the market appearing to be tiring after seven straight weekly S&P advances turned out to be quite prescient in the sense that the S&P did close lower last week after that number of weekly gains and then underwent its worst showing since November 7 to start the new week on Monday.

Last week saw a combination of two factors that caused the market to pause in the middle of the week, and they were the low level of the volatility index known as the VIX, and conflicting interpretations that were attached to the release of the minutes of last month’s F.O.M.C. meeting. I have mentioned in the past that when the VIX gets to a very low level, it means that investors are becoming too complacent because this indicator historically moves in the opposite direction of the overall stock market.

After the February 19 rally to the 1530 S&P level, the highest level for the year so far, the market was exhibiting extremely overbought tendencies, such as the fact that literally 90 percent of S&P members were trading above their 50-day moving averages. This is as good an example of overbought as there is and one which is corrected by stocks cooling off, so to speak, in order to get equities down to more reasonable valuations.

And the fact that this 1530 S&P level along with the very high percentage of stocks above those moving averages coincided with the VIX falling down to the 12.30 level, below which it has not gone since April 2007, meant that the only way the VIX could rise was for stocks to decline, which is exactly what happened last week.

The second factor contributing to a hesitation in the 2013 stock market overall advance was the statement from the Fed which said that “The committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved.” This basically meant that they were going to consider varying the amount of the current $85 billion in monthly asset purchases, but there is widespread disagreement among Fed members as to how and when this should be done, if in fact there should be any change in policy in the first place.

Interestingly, the Fed statement led to a sharp decline in the price of gold and other precious metals as they seem to have lost their supposed “safe-haven” status if investors feel that continued easing monetary stimulus is going to be withdrawn and interest rates could rise. As a result, the price of gold declined to its lowest level since last July, around $1,560 an ounce, from which it now appears that new buying might enter that market.

And perhaps the only good thing for consumers to come out of the Fed statement was that it caused energy prices to decline a bit, as crude oil close to $100 a barrel has always proved to be detrimental for stocks. Fortunately, crude oil prices appear to be having difficulty surpassing the $98 a barrel level and have declined back down to around $93, which should ease somewhat the highest ever gasoline prices at the pump for this time of the year.

After the stock market stabilized to the upside last Friday and early on Monday, the roof sort of caved in as the major averages underwent their worst showing since early November as mentioned above. The ostensible cause of the collapse, aside from the fact that the Dow Jones Industrial Average came within 83 points of its all-time high level on Monday’s opening, where the air perhaps gets a little too thin, was that supposedly investors were concerned over the huge protest vote by Italians enraged over economic difficulties and political corruption in that country. Because of this dissatisfaction, they pushed the political system toward deadlock as Monday’s election resulted in no coalition with enough votes to form a new government.

With more than two-thirds of the vote counted, projections showed that the center-left coalition might have a narrow lead in the lower house of parliament. On the other hand, no political party or coalition appeared to be able to attain a majority in the upper house or Senate, the result of which was a deadlock. This is the exact opposite of the result that was hoped for and that Italy desperately needs to deal with their recession that is expected to produce a negative G.D.P. of one percent this year, worse than the overall 0.3 percent economic decline for the E.U. region as a whole. This election result will make it more difficult to deal with this recession, the high rate of unemployment especially among younger voters and a huge public debt.

What must have spooked investors at the start of the week was that this political stalemate brings back bad memories of the Eurozone debt crises of recent years with a lack of clarity on whether there will be the austerity needed to end the economic uncertainty in the E.U.’s third largest economy.

As if the Italian political situation did not give investors enough to worry about, this coming Friday, March 1 could see $85 billion slashed from U.S. government budgets as the president warned about the harm that the cuts will do to Americans as he broke down the loss of jobs and services in each of the 50 states.  Naturally the Republicans, who are in favor of budget cuts, said that the president’s warning was a scare tactic and demanded that Mr. Obama deal with sequestration in a more deliberate manner rather than across-the-board budget slashing.

The president has urged lawmakers to buy some time for a more inclusive budget deal with a short-term proposal that would increase revenues by eliminating some tax breaks for the wealthiest Americans. Senate Democrats have proposed a plan that zeroes in on those tax loopholes and Republicans have said that they would put forward a plan of their own. In the meantime there have been practically no negotiations between the White House and Congress on these issues, as Republicans argue that the president can surely bring out a plan to eliminate two to three percent (the amount of the $85 billion sequestration) from a $3.5 trillion federal budget.

Meanwhile, as Friday’s deadline approaches, each side blames the other, with the president warning that hundreds of thousands of people could lose their jobs and Republicans claiming that the White House is using scare tactics.

Donald Selkin is the Chief Market Strategist at National Securities in New York, a veteran in the securities industry for 36 years who is widely quoted in the financial media.
If you have any questions, contact dselkin@nationalsecurities.com .