Trader's Diary

March 1, 2013 6:31 pm

Red lights flash after Italy’s elections

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Investors are looking for excuses to take profits

Loud warning bells ring for me whenever an event of only moderate importance triggers a painful share price drop. Last Monday’s 2 per cent decline on the S&P 500 index of leading US companies is a good example. The index was little changed in the first few hours of trading. But waves of selling began in the early afternoon as news of the Italian election deadlock began to hit the news wires.

UK investors followed Wall Street’s lead the following morning. The FTSE 100 fell by 120 points in the first few minutes of trading before partially recovering. My view is that the muddled state of Italian politics, although headline-making, is hardly new – and should have only a small effect on the profits of most UK and US companies. For this reason, I treated the sell-off as a clue that prices on both sides of the Atlantic had risen too much, too soon and nervous investors were looking for a reason to take profits.

Several trends that I regularly monitor continue to hint that shares are due for a short-term reversal in the near future. One is linked to a sudden decline in the value of sterling. At its recent low point, the pound had slipped 5 per cent against the US dollar in just 30 trading days. Drops of this magnitude in the past 30 years were virtually always associated with short-term stock market declines.

At first glance, it is counter-intuitive for a weaker currency to cause a stock market drop given that it helps exporters to increase foreign sales and makes UK shares cheaper for overseas investors. But history also suggests that sudden steep currency drops frequently signal the approach of serious economic problems.

There have been 30 instances in the last three decades when sterling fell steeply against the dollar in a 30-day period. The stock market declines that followed were around 6 per cent, on average. There were just two small dips of 2.5 per cent or less in the entire group.

At last week’s low point, the FTSE 100 had fallen by just 2 per cent since its recent peak on February 20. For those who value forecasts based upon past performance, there is a 93 per cent chance that this short-term stock market decline has further to go.

Another issue that worries me is the sudden flurry of poor news headlines. Within the space of a few days, we heard news about the Italian election, Moody’s downgrade of UK debt and another bout of bickering between President Obama and the Republican-dominated US Congress.

As I observed last week, stock market sell-offs of at least 5 per cent have occurred quite frequently in recent years when flurries of negative economic or political headlines frightened investors. A good example occurred in 2010 and 2011 when worries about the EU, US and a possible Chinese slowdown were associated with 12 short-term sell-offs. One struck every two months, on average,

David Schwartz
Commentators warn that focusing on deficit reduction with little emphasis on job creation or economic growth is making our economic problem even worse

- David Schwartz

We also enjoyed some longer-running rallies in the last four years. Invariably, they occurred when politicians behaved themselves and economic trends provided investors with hope for the future. The recent November to February rally is a good example of what might occur when the news flow is positive.

Unfortunately, the flood of recent economic and political headlines suggests that this period of mainly positive news is ending. The UK economy appears to be dead in the water with little hope of significant improvement in the foreseeable future. The government’s main economic policy continues to focus on cutting spending. It believes its “hang tough” policy will reassure the financial markets and lead to economic growth.

Growing numbers of commentators are warning that focusing on deficit reduction with little emphasis on job creation or economic growth is making our economic problem even worse. People like Trevor Greetham, Fidelity’s global asset allocation director, are saying that the US approach – stimulus now, deficit reduction later – is the right one, and claim that the economic data backs that up.

Chancellor George Osborne is having none of it, though. His reaction to Moody’s downgrade was defiant: “Far from weakening our resolve, this decision redoubles it.” And a faction within his own party wants even deeper cuts in public spending.

The row over economic strategy means that negative headlines, already more frequent than was the case even a few weeks ago, are likely to continue in the run-up to the Budget, just three weeks from now.

It goes without saying that there are no guarantees in the world of investing. But my opinion is that the likelihood of a further short-term decline in the near future is increasing.

Stock market historian David Schwartz is a short-term trader writing about his own trades. Comment online at FT.com/money, or email tradersdiary@ft.com

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