As world markets recoil at the harsh terms of the European Union's bank bailout for tiny Cyprus, expect plenty of soothing words from Stateside market partisans. The "this-too-shall-pass" crowd will point out the trivial economic profile of the Mediterranean island, decrying traders' knack for overreacting to weekend surprises and reiterating the sturdy economic fundamentals that, they'll tell you, continue to support stock indexes shadow-boxing all-time highs.
It is, of course, true that imposing principal losses on Cyprus bank depositors in itself shouldn't cause the sort of economic disruption that would justify hundreds of billions on global market value shifting at once. Which is why Monday's selloff in risk assets is best viewed here as a handy excuse -- rather than highly targeted cause -- for an overstretched stock market to pull back hard and undergo a reality check on its gentle and previously unflappable first-quarter rally. Here are a few reasons markets are registering significant concern -- aside from the obvious threat that the pain imposed on Cypriot banks' depositors could (though by no means is certain to) invite a flare-up of European debt contagion concerns for a fourth summer running.
This year's market pattern is uncomfortably familiar. As noted here lately (See: Will Stocks Third Time Around Be a Charm or Hex? and The 'Relentless Rally' of 2013 Tracks a Familiar Path), the U.S. stock market action so far this year has been a tight match for last year's first act and the run in early 2011. In each year, the Standard & Poor's 500 index levitated out of the gate, logging what might be considered a good year's worth of gains by the turn of spring, with volatility collapsing, economic confidence welling up and investors massing on the bullish side of the boat. Softer economic data, new signs of an unsettled Europe and U.S. budget standoffs led to deep pullbacks from 9% to 19% into summer each year.
The likeness with the 2012 experience was particularly close, with stocks, the volatility index (^VIX) and Treasury yields all sitting on very similar year-to-date moves by the week in March when stock options and futures expire, which this year occurred on Friday. Meanwhile, as the analysts at Nautilus Capital Research pointed out last week, since 2000 especially, March has seen more than its share of stock-market trend reversals, both epochal (2000, 2009) and shorter-lived.
Unexpected news and a sharp response
So the largely unexpected Cyprus news and some alarmed predictions of what it might mean for broader Continental financial stability arrived at just the moment when it could trigger some unpleasant deja vu among investors. Yet the news only had the power to elicit a sharp response because of how comfortably upbeat professional investors had become with a market that had come a long way in a short while.
Hedge funds' apparent exposure to stocks had, by some measures, reached a multi-year high, tens of billions began cycling into equity mutual funds and borrowing "on margin" against stock holdings approaching a record high, and surveys of market newsletter advisers showed rare extremes in bullish agreement.
Meantime, "smart-money" players who typically take the other side of over-popular public trades and tend to be prescient, came into the weekend with unusually large bearish bets against the major indexes, according to www.SentimenTrader.com.
Outside the upbeat U.S. market, China and other emerging-country stock markets have been lagging conspicuously behind, a cloudy signal for global-growth believers and evidence that investors were willing to bet heavily that the relative strength in the U.S. economy and the clarity of its supportive central bank could insulate it from some global anxieties.
The wait for a pullback
All this means is that this placid line-up of the optimists will be shaken up with this flurry of volatility. It's certainly true that legions of investors have been speaking of, and seemingly waiting for, a pullback to do more buying based on decent relative value in stocks and a crusading Federal Reserve -- which could certainly make any initial decline brief or shallow. On the other hand, a certain degree of the sponsorship of the rally has come from those encouraged by its steady, low-drama grind higher, including the recent run of 10 straight daily gains in the Dow industrials. This bout of volatility will sideline this "can't get 'em down" bandwagon corps for the moment. If the Cyprus scare proves as fleeting as the Italian-election jitters a month ago, the bull's reputation for endurance will only grow.
It should be said that, for all the familiar echoes, markets tend not to behave in such a predictable fashion beyond the point when the patterns become widely observed. Just last summer, it became common for investors to assume that the warm months would bring another unmooring of European debt markets beyond the reach or exceeding the resolve of the European Central Bank to contain. In 2010 and 2011, the S&P 500 lost at least 15% before being rescued by better domestic economic news and a fresh program of Fed largess. Many positioned for a similar outcome in 2012, but the ECB asserted an open-ended commitment to backstop government debt, and the selloff never got to 10%. As they say, just when you think the key to the market is at hand, someone changes the locks.
The knee-jerk response in currency markets to Cyprus has upended some crowded trades among the global mega-money. The flashpoint here is the Japanese yen, which all the world seems to expect to weaken even more dramatically than it has since new leadership in Tokyo vowed to use a cheaper yen to finally try to whip deflation. The mega-money globally has positioned itself to profit from en ever-sliding yen, while also borrowing yen voraciously for the purpose of buying higher-yielding, riskier assets. Borrowing in a currency that its overseers wish to cheapen is that much more tempting, given that one expects to repay the loan in lower-valued paper.
The Cyprus news jarred this trade, sending the yen shooting higher against the again-suspect euro, and spurring some selling in those riskier asset categories financed in yen. Investors can't do much more than watch how various asset classes behave in coming days and weeks to determine whether this is just a passing wave of risk aversion or something that has the power to knock loose some bit of the global financial apparatus.
For U.S. investors, the best read on how this asset-flow disturbance is playing out will be the performance of big financial stocks, especially global capital-markets hubs such as Goldman Sachs Grup Inc. (GS), Morgan Stanley (MS), J.P. Morgan Chase & Co. (JPM) and Citigroup Inc. (C), a key leadership group now working to tune their balance sheets for the approaching end of the quarter.
Taken all together, the Cypriot excuse will present a decent test of the predominant market narrative of 2013: That a domestic economic recovery becoming self-reinforcing and a Fed intent on waiting as long as possible to temper its emergency-level monetary support could keep U.S. stocks rolling higher regardless of what is happening inside the imperfect unions across the rest of the world.