PLUNGE IN EMERGING MARKETS CAUSES GLOBAL DOWNTURN IN STOCKS -- CHINESE STOCKS TUMBLE ON WEAK ECONOMIC NEWS -- BOND RALLY FORWARNED OF POSSIBLE STOCK CORRECTION EARLIER IN THE MONTH

PLUNGE IN EMERGING CURRENCIES PULLS STOCKS LOWER ... My Wednesday message showed the close correlation between weak emerging market currencies and emerging market stocks. It showed the WisdomTree Emerging Currency Fund (CEW) threatening to break an important support line. The green line in Chart 1 shows that happening. After falling sharply on Thursday and Friday, the CEW closed just below its 2012/2013 lows. While all emerging currencies tumbled, the most notable collapses took place in Turkey and South America. Argentina and Venezuela were hit especially hard, with the latter suffering a de facto currency devaluation. Why that poses a problem is because a close linkage exists between emerging market stocks and currencies (as well as bonds). Chart 1 shows that Emerging Market iShares (red line) track very close with emerging currencies. The 6-month Correlation Coefficient (below chart) has a positive correlation of .79. Emerging market bonds denominated in local currencies also fell sharply. The subsequent plunge in emerging market assets caused a high-volume selloff in developed stock markets all over the world and a flight to quality into American, German, and Japanese government bonds. Gold prices also jumped. Although the U.S. dollar bounced on Friday, most currency money went into Europe and Japan. A jump in the Japanese yen pushed Japanese stocks sharply lower.

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Chart 1

DROP IN CHINESE STOCKS DIDN'T HELP ... My Wednesday message suggested that emerging markets needed a stronger Chinese stock market to recover from their current slump. Unfortunately, they didn't get that help. Chart 2 shows China iShares (FXI) plunging nearly 5% on the week. In so doing, the FXI tumbled to a five-month low and ended below its 200-day moving average. News that China's manufacturing sector had slipped into a contraction mode had an especially negative effect on emerging markets that export to China (mainly in Asia and Latin America). China is the world's biggest emerging market and the world's second largest economy. What happens to that economy and stock market has a big effect on markets everywhere else.

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Chart 2

BOND BOTTOM WARNED OF STOCK CORRECTION... My message from two weeks ago (Saturday, January 11) showed the bond market bouncing off its chart support at its August low and warned that a bond bounce could be hinting at a correction in stocks. That threat became much more of a reality this week. The green bars in Chart 3 Show the 20+ Year Treasury Bond iShares (TLT) surging to the highest level in three months. It's now approaching a test of its October high. What it does from there may offer a clue as to how deep a stock correction might be. A decisive close above the October high would most likely signal a bigger stock correction. The solid line shows the S&P 500 falling 2.6% this week to the lowest level in the new year. In so doing, the SPX broke a rising support line extending back to October. It's been two years since the SPX has suffered a correction of 10%, which suggests that one is probably overdue.

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Chart 3

DOW INDUSTRIALS HEADED FOR A TEST OF SUPPORT LEVELS... Arthur Hill showed some potential support levels for the S&P 500 and other market averages in yesterday's message. I'll focus on the Dow Industrials today. It's been three years since the Dow suffered a correction of at least 10% (2011) and two years since it lost 8% (using closing prices). It fell 7% in late 2012 and 5% earlier this year. So let's see what those two smaller numbers look like on its price chart. Chart 4 shows the Dow falling decisively below its 50-day average in heavy trading. That turned its short-term trend down and suggests a likely test of the support line drawn over its September high and December low. That would be a loss of 5% and would be a modest pullback. A drop of 7% would put the Dow back to its 200-day average which isn't unusual during a market correction. It last tested, and bounced off, that long-term support line last October. An official market correction requires a drop of 10%, which would bring the Dow close to important chart support along its October low. The weekly bars in Chart 5 show that a drop to last year's lows would also meet a rising support line drawn under the Dow's 2011-2012 support lines. That would represent an important test of its major uptrend.

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Chart 4

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Chart 5

REITS AND UTILITIES HOLD UP OKAY... My January 11 message also warned that January ended the "best three month" span of the year that starts in November, and suggested that it might not be too early to start some rotating out of 2013 stock winners into losers. Two groups that I mentioned in particular were utilities and REITs. I suggested that those two dividend-paying "bond proxies" would probably do better than most stocks if bond prices continued to rally and stocks corrected. So far, that has been the case. The relative strength lines in Chart 6 show that utilities (blue line) and REITS (red line) have been market leaders since the start of the year. Over the last week, consumer staples, homebuilders, and gold stocks also held up better than the rest of the markets as scared money looked for safer havens and bond yields fell.

Chart 6