What a week. The media is full of stories about sovereign risks causing a sharp reversal in sentiment and strong selling in a wide range of assets. Bears are proudly bragging that they called it right, ignoring the inconvenient fact that even stopped clocks tell the correct time twice a day. Yes, European peripheral fears increased this week, but the more poignant question is perhaps not what, nor who, but why – at least why now and not before?
After all, euro area peripheral country problems are not new. It may be true that existence consists of an infinite array of possible future outcomes; but in the financial markets, where futurism meets economics, it is fascinating how often we seem unable to escape such “slow motion train-wrecks.” And there are plenty of other potentially “inevitable” threats moving over the horizon too (think international trade battles).

Thus, the bears were in charge last week. The S&P 500 lost 0.7% last week, performing relatively well on the back of a plunging euro and a brave buying spree late on Friday – the Eurostoxx lost 4.7% and Spain’s Ibex index lost 7.7%. Emerging markets also coped relatively well, with the MXEF index belatedly dropping 3.8% as the true extent of risk aversion became clear.

Gold looked jumpy too, selling in correlation with equities, as we have predicted previously. Anyone who bought gold to hedge sovereign risk will now have to suffer a volatile market-to-market.

The gold trade may eventually work out. But for now, the cash is sloshing from developed nation to developed nation, and from asset class to asset class in a fruitless search of safe yield. Much of it will wind up in the emerging markets, but that investment universe is not big enough to offer security on the scale required by developed-world investment capital. When the alternatives have been exhausted, gold may finally begin to re-price relative to global money supply.

Regular readers will be watching this market dynamic with a calm curiosity. MM’s Outlook & Review turned cautious two weeks ago, after Obama launched a necessary but destabilising effort to clean up the US banking sector. Markets were already ripe for a fall, now it appears to be underway. With that in mind, we might best direct our attentions to considering how far the correction could proceed.

Fundamentally things look bad, as the market remains highly valued on forward and trailing earnings. Technically too, there are reasons to wonder. The 200 Day Moving Average is only 4.6% down on the SPX, if that doesn’t hold then the potential for a rout increases substantially. No wonder nervousness is high.

But, it is worth remembering that this is no ordinary market: Free money is a great driver and most assets have shown surprising resilience over the last year, faking to the downside only to push higher. With this in mind, it would be brazen to presume a one-way bear trade.

Even the Vix Index offers limited guidance. Two weeks ago it rallied more than 50% over the week, a clear sell signal? It is true that the Vix is both mean-reverting and mean-fleeing: A spike in volatility might reasonably be expected to precede further volatility. But, as the chart below shows, this is not a given. Over the past 20 years, there have been six instances of the Vix moving by more than 50% over five days. In the following three months, the S&P 500 was as likely to rise as it was to fall. That said, using these six instances, the expected return three months after a 50% one-week Vix jump is negative (-0.7%).

Chart 2: S&P 500 – 3 Month Reaction Post Vix Rally

There are plenty of good reasons to stay out of the game for now then; or at least to be highly selective about what you buy. Short-term avoid high beta and consumer dependent equities, treasuries from over-leveraged nations will represent a great buy, but this trade is not for the faint-hearted. “Quality” government paper looks under threat too, how long before the market starts to price risk into US, UK and German paper?

By contrast, the emerging markets, which are certainly not risk-free, offer apparent economic stability. For those willing to accept that economic management has improved globally in recent decades, surplus nation bonds offer appealing safety. And emerging market equities ought to rebound faster than their developed world peers, look for chances to build positions if the crisis continues.

Of course, the free-money factor may win the day again. But the upside looks limited. If the rebound comes this week then I would not want to chase it. Many investors have their downside hedged, but sentiment is highly volatile and there is a growing consensus willing the market to let off steam properly.

Here are some of the key data points we are watching for over the coming week:

Monday
Europe – Investor Confidence (Feb). Improvement MoM is little consolation when the print is still expected negative.

Thursday
US – Retail Sales (Jan), Inventories (Dec). Sales are expected up MoM and YoY, still off the pre-crisis peak but clawing their way back quite persistently. Inventories are believed to have (finally) risen in December.

Friday
Europe – 4Q GDP, Industrial Production(Dec). GDP is expected at -4%, rising slightly from its bottom mid year. Industrial production is also expected negative, but off the lows.
US –  Consumer Sentiment (Feb). Expected to continue edging up.