Sharp declines across the stock market on Friday left investors wondering if this is a bearish reversal or just the long, overdue correction everyone has been expecting. There was no shortage of potential catalysts but the spark that started the two-day stock market plunge was disappointing economic data out of China. Worries that growth in China might be slowing down fueled major declines in emerging markets and their currencies. It was all about currencies on Friday. The Argentinean peso, Brazilian real, South African rand, Thailand baht, Turkish lira, Ukrainian hryvnia, plus the U.S. dollar and Japanese yen were just a few of the currencies making headlines last week.

Believe it or not but just three (trading) days ago the small cap Russell 2000 index was hitting new all-time highs. The NASDAQ composite was trading at new 13-year highs. The S&P 500 was less than 1% from a new all-time high. On Thursday the Dow Jones Transportation average hit new all-time highs. However, by Friday's closing bell, the Russell was down -2.0% for the week. The NASDAQ lost -1.65% and the S&P 500 posted -2.6% decline for the week. The Dow Transports ($TRAN) clocked in a -2.2% weekly loss thanks to a -4.1% plunge on Friday. That was the biggest one-day drop for the $TRAN in over two years. The collapse in the transports appeared to be a reaction to a disappointing earnings report from railroad company Kansas City Southern (KSU), which missed estimates by seven cents. Shares of KSU collapsed with a -$18 drop (-15%) on Friday. We are just over three weeks into January and all of the major U.S. indices are now negative for 2014.

The sharp drop in stock prices has produced a big bounce for the volatility index (a.k.a. the "fear gauge"). The VIX surged +31.7% on Friday to close at new three-month highs above 18. When the VIX spikes over 20 it can signal a potential bottom for stocks but using the VIX as a entry and exit tool can be tricky. Back in 2011 we saw the VIX spike up to 45 and during the 2008 financial crisis and market meltdown the VIX hit unheard of levels above 80.

60-minute chart of the Volatility Index:

Weekly chart of the Volatility Index:

Economic Data

U.S. economic data did not have much impact on the market last week. The Chicago Federal Reserve National Activity index was weak with a drop from 0.69 to 0.16. Numbers below above zero suggest growth but it's moving the wrong way. We also saw the existing home sales numbers for December, which came in at an annual pace of 4.87 million units. Economists were expecting 4.9 million. The prior month's reading was revised lower from 4.9 to 4.82 million. Decembers results ended a very strong year for real estate in 2013 with the sale of existing homes hitting seven-year highs. Unfortunately the momentum seems to be slowing down.

Overseas Data

Most of the economic data in Europe was relatively bullish. Yet that did not stop the various European stock markets from plunging -3% on Friday. The Greek and Spanish stock market's had really rough weeks with -5.8% and -6.7% declines, respectively. Spain is suffering from staggering unemployment with the latest data showing Spanish unemployment rising to another all-time high of 26%. Spain's trade deficit continues to worsen hitting 1.76 billion euros, up from 1.36 billion.

The news was much better for the wider Eurozone. The manufacturing PMI for the Eurozone rose from 52.7 to 53.9, which was better than expecting. The Eurozone ZEW economic sentiment survey improved from 68.3 to 73.3, another better than expected read. Germany helped drive these gains with German manufacturing PMI rising from 54.3 to 56.3. Germany's ZEW economic sentiment poll dipped slightly from 62.0 to 61.7. Economists want to see the PMI data above 50.0, which indicates growth.

The tone of economic data in Asia was also bullish except for one significant report. The Bank of Japan left interest rates unchanged in the 0.0% to 0.1% range. Comments from BoJ officials that their economy appears to be improving and that they do not see the need for more stimulus at this time would normally seem bullish. Yet these comments helped spike the Japanese yen, which saw a sharp two-day rally just as the U.S. stock market dropped and emerging market currencies plunged. A rising yen makes Japanese exports more expensive and would slow economic growth.

Weekly chart of the Japanese Yen ETF:

It was Chinese economic data moving the market. Last week the Chinese government said December retail sales rose +13.6% over a year ago, which was in-line with forecasts. Industrial production improved +9.7%, which was also near expectations. Their Q4 GDP estimate came in at +1.8%. That was slightly below expectations but their full-year GDP growth estimate rose to +7.7%, which should have been bullish for the equity markets.

The problem is that analysts are worried the Chinese economy is slowing down. A Bloomberg survey of fifty analysts expects Chinese GDP growth to slow down to a 24-year low of +7.4% this year. On Thursday the global stock markets dropped following the HSBC Markit PMI report on Chinese PMI, which fell to a six-month low at 49.6. Numbers below 50.0 suggest economic contraction. If the Chinese economy is contracting then that could mean less demand for imported raw materials from many of the emerging markets that China buys from. Thus the already weak emerging market currencies were kicked in the gut with this recessionary PMI number from China. The official Chinese PMI data will not be released until February 1st. While most market pundits believe the official numbers are massaged to look better than reality the trend has been down with the official PMI for November at 51.4 and December's at 51.0.

Yet another problem for China are stories that the government is struggling to contain its $4.8 trillion "shadow banking" system. A Financial Times story this past week discussed the Chinese government dealing with a $500 million high-yield investment trust that was on the verge of defaulting. If this defaults it would seriously damage investor sentiment. If that wasn't enough there are also reports that China is suffering from a shortage of cash in its financial system.

Emerging Markets

The recessionary economic PMI data from China on Thursday yanked the rug out from under the already weak emerging markets. Many emerging market currencies started to weaken back in May 2013 when the U.S. Federal Reserve hinted at tapering their QE program. When the Fed actually began its taper last month this accelerated some of the weakness overseas. Argentina made headlines as it devalued its currency for the second time since 2002. The Argentina economy is struggling with inflation. Officially inflation is only at +10% a year but outside the Argentine government inflation estimates are in the +25% to +28% range. Their currency reserves plunged 30% last year and currently sit at seven-year lows. After the devaluation the Argentine peso was worth about 8 pesos per U.S. dollar but on the black market they were down to 13 pesos per dollar. In what seems like an act of desperation the Argentine government just launched a +50% tax on Internet purchases. Citizens can buy up to $25 worth tax free per year. Above $25 you have to pay a 50% tax on each item. Argentineans now have to go to their local customs office to pick up packages from or Ebay.

Argentina is not the only country with a sinking currency. Brazil, Venezuela, India, Ukraine, Turkey, and Thailand continued to see their currencies accelerate lower. The situation in Ukraine, Turkey, and Thailand is exacerbated by civil unrest. There are massive anti-government protests in Ukraine and Thailand and they're starting to turn violent. Turkey has seen major protests recently and its prime minister has been unable to soothe the ongoing corruption scandal. Speaking of violent protests we're seeing renewed violence in Egypt as well. There was no shortage of reasons for investors to worry on Friday. The approaching weekend was another impetus for traders to hit the sell button. Countries tend to devalue their currencies over a weekend when their financial markets are closed. You can read more about what Bloomberg is calling the worst emerging market currency crisis in five years here.

Major Indices:

The S&P 500 index ended 2013 at all-time highs just below potential round-number resistance at the 1850 level. The 1850 level has continued to be overhead resistance. The market's sell-off this past week has left the S&P 500 with its first close below the rising 50-dma in over three months.

It's possible the 1800 level could hold as round-number support. However, we suspect that there is more selling to come. The S&P 500 is likely headed for the December lows near 1770-1775. If that level doesn't hold then the 1750 level has a good shot at being support since it is underpinned by a trend line of higher lows.

Last week I cautioned investors that a normal -3% to -5% pullback would mean a drop toward the 1795-1757 range. A -10% correction would be 1665.

chart of the S&P 500 index:

The NASDAQ composite tagged a new 13-year high on Wednesday. Unfortunately Thursday's drop turned that into a candlestick island reversal pattern. The next level of support appears to be the 4100 level and below that the simple 50-dma near 4080.

A normal -3% to -5% correction for the NASDAQ would mean a drop into the 4115 to 4030 range. A typical -10% correction would mean a drop toward 3818. At the moment the overall pattern is still bullish and the NASDAQ has not yet broken its bullish trend of higher lows. I will point out that the weekly chart for the NASDAQ has created a bearish engulfing candlestick reversal pattern but it needs to see confirmation.

chart of the NASDAQ Composite index:

The small cap Russell 2000 index settled with a -2.0% drop for the week thanks to a -2.4% plunge on Friday. The 1135-1140 area could be support since it is underpinned by the 50-dma and a trend line of higher lows. If this level fails then the next likely support area is probably 1100.

A normal -3% to -5% correction would mean a pullback into the 1145 to 1122 zone. A breakdown below 1120 would mean the long-term up trend is in jeopardy. A normal -10% correction would mean a drop toward 1063.

chart of the Russell 2000 index

Economic Data & Event Calendar

We have a relatively busy week of economic reports and events. The ones to watch are probably President Obama's State of the Union speech on Tuesday, the FOMC decision on Wednesday, and the U.S. GDP number on Thursday. This will be Ben Bernanke's last FOMC meeting as Fed Chairman. Most believe that the Fed will taper another $10 billion at this meeting. If they alter the taper to something other than $10 billion it could be market moving and likely negative.

Economic and Event Calendar

- Monday, January 27 -
Moody's Business Confidence survey
New Home Sales

- Tuesday, January 28 -
Durable Goods Orders
Case-Shiller 20-city home price index
Richmond Federal Reserve manufacturing survey
State of the Union speech by President Obama
Consumer Confidence for January
FOMC meeting begins

- Wednesday, January 29 -
FOMC policy update

- Thursday, January 30 -
Weekly Initial Jobless Claims
Eurozone consumer confidence data
U.S. GDP estimate for Q4
pending home sales data

- Friday, January 31 -
Eurozone unemployment data
China manufacturing PMI data
Personal income & spending data from December
Chicago ISM/PMI data

Additional Events to be aware of:

Feb. 7th - U.S. debt ceiling is reached
Mar. 19th - FOMC policy update and economic projections
Mar. 19th - new Fed Chairman Yellen's first press conference

Looking Ahead:

As we look ahead the question on everyone's mind will be, "is this a bearish reversal or just a normal correction?" The U.S. stock market has been way overdue for a correction and we should probably treat it as such until we have more data. If we see the major U.S. indices break down below their long-term trend lines of higher lows then we'll probably hear more talk about any potential reversal.

Bespoke Investment Group pointed out that in spite of the market's recent volatility we are on track for a normal January performance with the low for the month occurring last week. If this year holds true to the 20-year average then stocks should post gains by next Friday.

Odds are good that the market will see more selling on Monday morning. I've mentioned multiple times over the last month or two how margin debt has been at or near record highs. The sharp sell-off last week may have sparked some margin calls. Monday could see some margin call selling. The question becomes where will traders step in and buy this "dip"?

We are still in the middle of Q4 earnings season. Thus far the results appear to be in-line with the averages. There are always stand out winners and losers every earnings season but according to the S&P we've seen 63% of companies beat estimates, 12% reported in-line, and 25% have missed. Compare that to the prior four quarters of 67% beating, 10% hitting estimates, and 23% missing (editor's note: last week I listed the average beat at 69%). Last week's results actually improved the Q4 average since a week ago only 50% of companies reporting had beat estimates.

If you missed last week's letter then I want to repeat the observations about how much we are overdue for a correction. The U.S. stock market has not seen a 20% correction in over 840 days. Stocks haven't seen a -10% correction since August 2011. The closest thing to a correction was a -9.9% drop in May 2012. A normal market will see a -10% correction about twice a year.