Emerging markets and South America all contributed to a massive sell off in the global markets on Friday.

Market Statistics

The BRICs, Brazil, Russia, India and China plus Japan, Mexico, Venezuela, Argentina, Egypt, Ukraine, Thailand and Turkey all contributed to the global market decline. Each had their own brand of problems but together they severely dampened the outlook for the global economy.

Violence in Ukraine accelerated as protestors took over government buildings.

China's economy fell back into contraction according to the HSBC Markit PMI at 49.6 and a 6 month low.

China's $4.8 trillion shadow banking system is crumbling around the edges and China may not want or be able to bail them out.

Argentina significantly devalued its currency as inflation soars. Initiated a 50% tax on Internet purchases to drive sales to brick and mortar stores and keep the money from leaving the country. All online purchases must be delivered to a customs office where the buyer can pick them up and pay the tax. Currency falls the most in 12 years. The government froze prices on 200 food items with inflation over 25%.

Brazil's real fell to a five-month low after losing -28% over the last two years.

Egypt saw major bombings as a new wave of radical Islamist violence increases.

Turkey's corruption scandal is rapidly increasing and the lira hits record lows despite an unscheduled intervention by the central bank.

Violence in Thailand increased and the currency fell even lower.

Japan's yen rebounded sharply on comments from Abe and the yen carry trade imploded.

Venezuela is on the verge of collapse on soaring inflation and the nationalism of the private sector. International currency reserves are at a 10-year low.

Russia is losing control of the Olympics with hundreds of thousands of tickets unsold over worries of terrorist attacks. The 40,000 man security force has locked down Sochi with metal detectors more plentiful than restrooms but terrorists still claim they are going to make this the bloodiest Olympics ever.

Bloomberg claims the contagion spreading to global markets is the worst selloff in emerging market currencies in five years.

I have warned several times over the last several weeks to not ignore the rising problems in the smaller nations. In 1997 the collapse of the relatively insignificant Thai Baht led to the Asian Contagion and eventually the collapse of Long Term Capital Management and potential collapse of the U.S. financial system were it not for Fed intervention. Today the collapse of the Argentine currency and impending collapse of the Venezuelan economy are not critically important to the U.S. markets but they are important.

Each of the events I listed above would not be terribly important on their own to the U.S. markets but when seen as a group they seem to be symptoms of a bigger problem. Some of the currency declines are related to the current tapering of QE. Declining economic conditions related to political instability and rising interest rates in the U.S. make the U.S. a more desirable place to invest and money is flowing out of the emerging markets and that pushes their currency lower. This upsets the tenuous economic balance in these countries and can push them off the economic cliff.

Bloomberg chief economist Michael McDonough tweeted this chart showing how emerging market currencies began to fall as U.S. yields began to rise on the prospect of tapering. The top line is the ten-year yield. The yellow line is Asia and blue line is Latin America. When money flows out of emerging markets the liquidity needed to run their economies shrinks. The UK, BoE and BoJ are also making comments that are pushing their currencies higher and increasing the problems in emerging markets.

Art Cashin pointed out that we have to be worried about potential contagion where the number of countries in trouble grows as the problems from one country erodes confidence in a neighbor or trading partner.

The high number of guidance warnings with the Q4 earnings plus the geopolitical events above combined to weaken the fundamental components of the market.

Do not forget the QE taper process. The initial taper announcement in December failed to move the market because of the seasonal year-end rally. Now that we are in 2014 and momentum has slowed, the FOMC meeting next week became a larger speed bump for the market. This is especially true with recent comments from Fed members about accelerating the pace of the taper. When the market did not react to the initial taper announcement in December it emboldened the hawks on the Fed to consider a faster pace and mention those thoughts in their speeches.

As we came into 2014 and momentum slowed those investors holding huge profits from 2013 started to become nervous. The longer the lack of momentum lasted the more nervous these investors got. As the global news worsened investors simply gave up on the "hope" trade and began taking profits. Once the selling began it started feeding on itself as stop losses were hit and the declines accelerated. When it appeared the Nasdaq and Russell were not able to hold their gains the traders joined investors in the race for the exits and the rest as they say is history.

There were no economic reports of note on Friday.

Next week has a busy economic calendar but the various reports are not that market moving with the possible exception of the GDP. With growth expected to decline from 4.13% to 3.0% any number significantly different could push the market around.

The biggest event for next week is the FOMC meeting and the taper announcement. The sharp decline in the markets probably spooked the hawks away from pushing for a faster taper. The emerging markets are too weak for the Fed to accelerate since that would push our interest rates higher and further endanger emerging market currencies.

The Fed is likely to announce a cut of another $10 billion in QE simply because the market expects it. It took them a long time to get the taper started and to stop it after only one month would show indecision and a lack of confidence in their analysis. Stopping it now could actually confuse the market and it would start the countdown clock all over again.

This is Bernanke's last meeting and I am sure he will be pushing for a continuation so he can point to history later and say, "I had the taper well on its way when I left." If Yellen wants to change the speed or direction at the March 19th meeting that will be up to her. She will have two more jobs reports before that meeting plus a lot more economic data.

There were some gains on Friday but in an area that won't do many investors much good. Natural gas spiked more than +19% in just the last week and +44% since November to close at $5.17 and the highest level since June 2010. The record draws from storage as a result of the coldest winter in years has caused serious concerns that there will not be enough gas to make it through the winter without shortages. Four of the top ten coldest days this century occurred this January.

We only produce about 70 Bcf per day and the prior week we consumed 111 Bcf per day. This caused a record withdrawal from storage of -287 Bcf for the week. With only 2,423 Bcf in storage that rate of decline would put us dangerously low in the weeks ahead. Another problem is the freeze outs caused by the super cold weather. When temperatures move significantly below freezing it causes "freeze outs" where the wells quit producing until the weather warms up enough to thaw them out and be restarted. This means we are not producing at that 70 Bcf per day level and that will produce larger draws from storage.

The spike in gas prices will cause significantly higher utility bills for the 50+ million homes heated with natural gas or using electricity generated by natural gas. With colder weather forecast through mid February this is going to reduce discretionary income and lower spending by consumers in Q1. The 14 million consumers that use propane are already seeing monster increases in prices. Consumers in the Midwest have seen prices rise almost 100% over the last three months as the cold weather pushed the supply of propane in inventory to only 20 days and produced shortages in some areas.

I filled my tank in early November at $2.29 per gallon. I refilled it on Thursday and it cost me $3.87 per gallon. That is a significant hit to propane consumers. Propane prices in the Midwest soared to a record premium to prices on the Gulf Coast with propane in Conway Kansas ranging from $3.62 to $4.50 per gallon on Friday. Conway is one of the top two U.S. storage hubs. Supplies in the Midwest fell to 10.2 million barrels and the lowest level for mid January since the EIA began keeping data in 1993. The Cochin pipeline operated by Kinder Morgan is operating well below capacity at 50,000 bpd because there is not enough supply to fill it.

The Dow Transports ($TRAN) were knocked for a -4.1% loss after Kansas City Southern (KSU) reported earnings that missed estimates and the stock crashed -15% or -$18. KSU posted earnings of $1.03 compared to estimates of $1.09. Revenue was $615.6 million compared to estimates of $618.6 million. While the earnings were not a really big miss the outlook and several downgraded pushed the stock lower. Earnings from shipping energy fell -17% because of dwindling coal loads. KSU said coal volumes had been weak but crude volumes had risen +51% in 2013. However, crude volumes declined -8% in Q4 as refiner demand for light Bakken crude declined in the Gulf region. The company said it was "working on several more opportunities" to move heavy Canadian crude to the Gulf Coast. They expect Canadian volumes to rise after they get specialized offloading equipment installed at various destination points. Refiners in the Gulf are setup to refine the heavy sour imported crude so they would prefer the heavy Canadian crude instead of the light Bakken crude. Heavier crude produces more products like diesel along with the gasoline. KSU is committed to completing a terminal in Port Arthur that will handle a 120 car train per day of heavy crude. Port Arthur has nearly 1.0 mbpd of refining capacity from three major refineries.

KSU won't have to worry about coal volume in the coming months. With natural gas well over the breakeven rate of $3 per mcf the utilities with dual mode capability will be burning 100% coal. Peabody Energy (BTU) said coal demand began rising as soon as that $3 level was breached and it should have accelerated after gas prices rose over $4 in early December.

Google (GOOG) shares fell -$36 after millions of Gmail users suffered an outage on Friday. Google Calendar, Google Docs and Google Talk were also impacted. Google offered no explanation for the outage. Gmail has more than 366 million desktop PC users compared to 273 million for Yahoo and 242 million for Microsoft's Outlook.com.

Google's Motorola Mobility unit lost an antitrust lawsuit against Samsung and Sharp for price fixing the LCD screens used in their mobile phones. Motorola had claimed it was hurt by the price fixing for displays Motorola purchased outside the country where it assembled the phones for later sale in the USA. The judge said he could not rule for Motorola because the transactions in question were "overwhelmingly foreign in nature." Only 1% of the $5.4 billion in purchases were sales to Motorola in the United States. So apparently price fixing is ok as long as it is outside the US. Motorola said it disagreed with the court's ruling since the majority of those foreign purchases were for phones eventually sold in the US. There will probably be an appeal. Google will not give up.

The Volatility Index surged +32% on Friday to close at 18.14. That is the highest level in three months and it is closing in on the 21 level that corresponded with buying opportunities over the last year. Investors were buying millions of puts to protect their positions as the market decline accelerated. While the VIX can go a lot higher it typically stalls out over 20 as market sell offs run their course. Only serious market events are capable of pushing the index into the 30 range or higher.

As you can see by the chart the +32% spike on Friday was barely noticeable over the longer trend. Until it moves over 21-22 this is just a garden variety sell off.

U.S. treasuries saw heavy buying on Friday with equities crashing and worries about a contagion of the multiple currency issues around the world. Contrary to conventional wisdom the yield on the ten-year has been in decline since the Fed announced the taper in December. The Fed's guarantee that rates will remain near zero well into 2016 appears to have delayed the eventual rise in treasury yields. The multiple currency challenges around the world have created a flight to quality into U.S. treasuries.

The global turmoil has lifted gold from its December 31st low of $1,181 to close at $1,263 on Friday. Suddenly gold has regained its hedge status and could reach $1,300 next week if the global unrest continues. This is also a seasonal bounce. Historically funds sell gold in December and put the money into stocks for the year-end statements. In January they start to rebuild their gold positions as a hedge against events like we saw last week.

Bank America analyst MacNeil Curry warned on Thursday that above $1,270 gold could become explosive as the short squeeze trap slams shut. The target would be $1,362-$1,394.

Don't look now but the physical gold shortage is growing. Everyone knows that JP Morgan is one of the biggest gold holders on the planet. They store gold for themselves and others. On Thursday JPM reported the single largest withdrawal in history at -321,500 ounces. Actually that was a tie with December 13th, 2012 when exactly 321,500 ounces were also withdrawn. Registered gold in JPM vaults has fallen to the lowest level in history at 87,000 ounces. Registered gold at all Comex warehouses has hit a new low at 400,000 ounces. Comex claims there is a huge 92 owners per registered ounce today. Registered ounces are available for delivery to settle futures contracts. In other words the registered ounces are all that is backing up the existing futures contracts. Since the majority of futures contracts are never held until the delivery date there are tens of thousands more contracts then actual gold. If everyone suddenly began demanding delivery of the gold referenced by the futures contracts we would be in serious trouble.

On January 17th there were roughly 500,000 registered ounces. At that time there were 111.6 owners per ounce. There are currently 41.309 million ounces being traded through futures contracts. This is "paper gold" not real gold. Where else but America could we be trading 41 million ounces of futures against 500,000 registered ounces? Obviously if only a fraction of the holders of those futures contracts began demanding delivery the price of gold would be much higher.

We are currently seeing all time lows in registered gold and all time highs in claims against that gold. What is wrong with this picture?

The Q4 earnings cycle is really hard to quantify. Officially S&P says of the 102 companies that have reported earnings 63% have beaten, 12% reported in line with estimates and 25% missed expectations. That is right in line with the averages over the last four quarters of 67%, 10% and 23%. Stuart Freeman at Wells Fargo claims only 59% have beaten compared to 67.2% in Q3. S&P claims we are on track for +5.4% EPS growth in Q4.

The problem occurs in the guidance. It is very hard to track the guidance since companies revise it all the time. For Q4 94 S&P companies lowered their guidance through December. Quite a few more have warned since but nobody keeps an accurate track. Reported revenues are basically flat and showing no growth. Only cost cutting and stock buybacks have pushed bottom line earnings growth to that 5.4% level.

The big earnings for next week are Apple, Amazon, Yahoo, Facebook and Google.


So what should we expect next week ahead of the Fed decision on Wednesday? Nobody can predict that accurately but there are a few facts to consider. First, currency problems don't end overnight. They keep going and going and going. Once a run begins it is very hard to stop and we have multiple countries with currency problems not just one. The contagion has already begun. This suggests the market weakness could continue.

The U.S. markets were being supported by record high levels of margin debt. That means the average investor was leveraged to the hilt in expectations of 2014 repeating the 2013 gains. After the Dow dropped nearly -600 points last week those margin balances are in trouble. The -318 point decline on Friday will have pushed most investors into deficit territory and Monday could see a lot of margin selling. Those broker notices will be going out this weekend and investors will be forced to sell something early Monday or the broker's computer will pick something to sell by 2:PM. There is no time to wire more cash to your accounts. The only recourse is to sell something to raise cash levels in the account.

Weak holders are being flushed. Anyone with a large amount of stocks bought on margin is really hurting this weekend. All their gains will have turned to losses and their account balances have shrunk. This will limit their ability to buy any rebound.

The markets continued to sell off after the close of regular trading. The S&P cash closed at 1790.75 and the S&P futures dropped another -1.50 in afterhours to close at 1,780.25. The volume of 8.78 billion shares was the highest non-expiration day volume since June. Declining issues were 6:1 over advancers. Not quite a 10:1 day but still very negative.

The acceleration of selling at the close was due to weekend worry. Countries normally use the weekend when markets are closed to "adjust" their currencies. Given the number of countries under stress we could see several make adjustments and intervene to halt the decline in their currencies. Investors did not want to be long over the weekend with numerous events possible. Friday is normally a short covering day but nobody was even thinking about covering shorts at the close. In the Middle East and Northern Africa the weekend is when the largest protests and demonstrations appear. With serious bombings in Egypt, Turkey collapsing and Syria about to walk out of the peace talks, anything was possible.

Bull market corrections are normally short, sharp and scary. Friday definitely fulfilled those conditions. The markets were looking for an excuse to rally in January and could not find one. When the markets could not find a reason to rally and earnings began to disappoint it turned into a hunt for an excuse to sell. The myriad of global events turned into a perfect storm and the Dow posted its biggest decline in six months.

With the Dow down -4.2% for the year, S&P -3.1%, Nasdaq -1.2% and Russell 2000 -1.7% the selloff, although sharp and scary, is just a garden variety bout of profit taking so far. We have gone 412 days without a 10% correction and we normally have 2.2 per year so we are overdue.

To qualify as a 10% correction the Dow would have to fall another -1,000 points to 14,918, S&P another -130 to 1,664 and Nasdaq -310 to 3,819. To put that in perspective the Nasdaq lost -69 points for the week and the S&P -48. The Dow has been the weakest link so another -1,000 points is not a big stretch.

Bespoke Investments created a composite chart of January for the last 20 years. So far the pattern has been right on schedule with the average low for the month on January 24th, which just happened to be Friday. The last week of January is normally bullish with the last three days of the month higher. Let's hope this seasonality remains on track.

Bespoke Chart for Dec/Jan Last 20 Years

The S&P collapsed below the 50 day average at 1,812 and round number support at 1,800 to close at 1,790. While the 50-day is a sentiment average the stronger support for the S&P is the 100-day now at 1,763. That would be a drop of another -27 points and it is certainly possible. The 1,775 level is also strong support and based on the speed of the decline and the potential for margin selling on Monday I think that level is definitely possible and it should provide significant support. Those traders waiting on the sidelines for a dip should be clicking the buy button at that level if not before. Typically there is a subset of aggressive traders that anticipate a support level and launch their trades a few points early in order to be assured they don't miss the bounce.

The S&P stopped its decline at 1,790 and that exactly corresponds to the prior uptrend resistance from May. That uptrend line was first pierced on October 22nd and has functioned as support ever since. We can't read too much into the halt at that level at the close because the time expired or the selling would have continued.

For Monday, assuming the emerging markets do not melt down over the weekend, I would look to buy that 1,775 level or maybe a couple points higher for a short term trade. Currency problems don't go away overnight. That means any short term rebound will be dependent on a shrinking news flow out of those emerging economies. If the 1,775 level fails I would look to buy the dip again at the 100-day average currently 1,762. That level will attract fund managers because of its strong support history in 2013.

For several weeks I have been cautioning about loading up on longs unless the S&P moved over 1,850 and that never happened. If we do see a dip to the 100-day I would be somewhat aggressive on buying the dip but ready to immediately bail if that level was broken. The next material support would be 1,747 followed by the 200-day at 1,701. I sure don't want to go there but as long as you exit your current longs before they turn rotten that 200-day average would be a great buying opportunity.

The Dow broke well below 16,000 to close at 15,886. The Dow was already the weakest link and the plunge out of its downtrend channel was ugly. The 15,800 level is the next support level followed by 15,700. The Dow is not reactive to the short term averages like the 50/100 day because of its narrow 30 stock price weighted construction. Even the 200-day average has little influence. It is hard to show in the limited width space we have here but it is somewhat reactive to the 300-day average. It is hard to show a daily chart that is wide enough to illustrate the 300-day but that level is now 14,871.

If the Dow declined to the strong support of 14,750 that would be an 11% decline and fulfill the correction direction with room to spare.

More than half of the Dow components lost more than $1 and quite a few were significantly negative with Visa down -$7. The curse of the price weighted index was alive and well on Friday.

The Nasdaq Composite is nearing the 50-day average at 4,081 but this has not been strong support for the last year. The 50-day has been pierced five times in the last 13 months and it only acted as support in two other declines. The 100-day at 3,946 has only been tested once over the same period and it did spark an immediate rebound. The 200-day is well below at 3,713 and it has a mixed record of support over the last three years. If we get there we can talk about it again in greater detail.

Initial support is 4,100 followed by 4,000 and then 3,895. Each level is about equal in the expected quality of support although the farther we drop the greater the chance of a rebound from the next support level. The 3,895 level is about -230 points below Friday's close and while I am not predicting that severe of a drop I would expect it to hold. That would be an 8.2% decline from the 4,243 high close on the 22nd.

With the Nasdaq and the Russell 2000 the strongest indexes I would expect them to lag behind if the decline continues.

The tech index declined -91 points on Friday and as you can see by the severity of the declines on the losers list it was an ugly market.

The Russell 2000 was stronger than the Dow and S&P with a -1.7% decline YTD. However, it closed below strong support at 1,147 that held since early January. It was not a big break at -3 points to 1,144 but it still counts. Uptrend support is 1,130 followed by 1,096. The Russell tested the 100-day twice in 2013 and both times it held. It is currently 1,109. The 50-day has produced mixed results.

Monday will be margin call day. This suggests there will be at least a couple of downdrafts even if the market opens positive. Because of Friday's drop the headline flow from the emerging markets will be intensified even if there is little to report. Bad news always sells better than good news and reporters will be trying to milk the events for one more story.

Beware any really negative headlines from the emerging markets. With the market already unstable any really negative news could grease the skids on the downhill plunge. Quite often once a bearish direction is established it tends to quickly become overdone as it takes on a life of its own. Let's hope the anticipation over the FOMC meeting blunts any emerging markets hysteria.

The FOMC meeting begins on Tuesday and the decision is at 2:PM on Wednesday. I believe we could see some buying on Wednesday in anticipation of a neutral outcome with the Fed staying the course and opting to reduce the QE by another $10 billion. This is what the market expects and the best surprise is no surprise at all.

Enter passively and exit aggressively!

Jim Brown

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