Worldwide Equity Rout Continues As Bond Yields Decline

So far in 2014, the stock market has gotten everything thrown in its path except the proverbial kitchen sink, as the worst month for the S&P since May 2012 (January) was followed by the first trading day of February this past Monday with the Nasdaq suffering its worst-ever start to February in history! And those statistics are representative of the awful performance that stocks have undergone after having finished 2013 with their best showing since 1997.

For starters, the market finished lower in January for the first time since 2010. The Dow ended the first month of the year with a 5.3 percent decline, while the S&P gave back 3.6 percent and broke a streak of winning months going back to last August.

This means that the January barometer is now in play, so to speak, as history says that during the last 85 years, or since the advent of the S&P back in 1928, this indicator has been correct on 62 of those occasions, or 73 percent of the time, meaning that the market goes in the same direction for the entire year as it went in January. The S&P has followed January’s direction 80 percent of the time when the first month of the year is higher, but only 60 percent of the time when it is lower to start the year. This lower correlation on the downside means that the bullish contingent should not give up hope that 2014 will turn out well, despite the rocky start.

After the miserable performance in January, the Nasdaq’s first-day loss of February was its worst one-day decline since June 2012. the Dow hit a three-month low; 491 of the 500 S&P stocks were down on Monday, the worst such showing since August, and the S&P has now declined by 5.8 percent this year.

This drop exactly matches the late May to late June market downside swoon after the Federal Reserve first threw out the trial balloon about the fact that they were going to start tapering the $85 billion a month in bond-buying stimulus sometime in the future. They finally made the announcement in December that the tapering would begin in January at the rate of $10 billion a month, until it is completely worn down by the end of 2014.

So what is going on here? The start of 2014 in financial markets is going in the complete opposite direction from what most market experts had predicted would happen, in the sense that fixed income bond markets have posted their best January returns since 2008, and equity markets have undergone their worst start to a year since 2010, as mentioned above. And gold, given up as a lost cause after its largest annual decline since 1981 and its first loss in 13 years, is ahead by five percent.

As the Federal Reserve was going to start to taper its bond-buying program and worldwide economies started to pick up steam, the consensus investment strategy for 2014 was to buy stocks and avoid bonds. Unfortunately, the best laid plans of mice and men sometimes get turned upside down, which is certainly what has taken place so far.

The initial jolt was the December jobs report, which showed that only 74,000 new positions were created, well below the expectation of 195,000. Almost two weeks later, a report from China showed that manufacturing in that country had declined in December for the first time in six months. And on Monday, another report showed that Chinese manufacturing had declined in January as well.

The woes from that part of the world intensified when it was reported that a high-yield trust, similar to the toxic collateralized mortgage obligations that were largely responsible for causing the worldwide financial meltdown in 2008, had threatened to default.

These events led to concern that emerging market countries that supply raw materials to China would also undergo an economic slowdown. Adding to these emerging market woes, Argentina’s peso began a decline to the lowest level in five years against the dollar as their central bank cut back on dollar sales in order to maintain international reserves that fell to a seven-year low.

Then the central banks of India, South Africa and Turkey all raised interest rates in order to defend the value of their currencies, which had fallen to multi-year or record lows against the dollar.

Last Wednesday, the Federal Reserve announced that they will now taper their monthly bond-buying program down to $65 billion a month, resulting in further anxiety that one of the major props supporting the tremendous gains in equities since the March 2009 bottom was being chipped away.

At the same time that equities have been declining, yields on Treasury securities have been falling as well, as the all-important 10-year note has dropped from a three year high at over 3 percent at the start of January, down to 2.59 percent during Mondaydownside market disaster, which was their lowest yield since October. This rush into bonds has been a classic case of the old “flight to safety” syndrome at work, where investors shun risky assets like stocks for the ostensible safety of government bonds, and even gold to some extent.

Monday’s market rout, which saw the Dow decline by 326 points, was caused by the January ISM Manufacturing Survey declining to its lowest level in eight months, which was the largest one-month fall in 33 years. This, along with other recent tepid reports such as the lowest reading for December home sales since May 2010, December durable goods orders falling by the most in five months, and December new home sales dropping by more than expected as well, has left many wondering if the U.S. economy is in fact losing steam.

All of these anxieties have resulted in the volatility index, otherwise known as the VIX, rising to its highest level since December 2012, as it has now gained over 50 percent in 2014 as stocks have declined. This reading for the VIX in the low 20s area might be a good indication that equities have gotten oversold and those investors who missed the huge 2013 run-up in prices might want to start nibbling at these lower levels in companies that have fallen back to more reasonable price levels and might now represent good value.


 

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.