How Fast Is the Sky Falling?

03/06/2012 4:52 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Today’s drop isn’t too surprising, but news out of Europe later this week could give the markets a real shock, writes MoneyShow’s Jim Jubak, also of Jubak’s Picks.

Is this the correction that has been looming as a possibility for weeks?

The S&P 500 Index is down about 1.5%. The German Dax Index closed down 3.4%, and Hong Kong’s Hang Seng Index fell 2.2% overnight. Today’s action followed on yesterday’s drop.

Sure looks like it, no?

Well, it depends. The markets are clearly down, but investors won’t know whether or not this goes from being a reaction to worries over the Greek debt swap to a true correction of 8% to 10% or so until Thursday and Friday of this week.

As you can tell from the larger drop in the Dax than in the S&P, the locus of fear today is Europe and the Greek debt swap that is supposed to close on Thursday.

Greece has said that it needs 75% of the holders of its debt to agree to swap their old bonds for new bonds—with a smaller face value and a lower interest rate—to give it enough relief to meet the requirements of the new Eurozone rescue package. Less than 75%, and everything so painfully pieced together over the last month will come apart.

Greece does have the ability to force bondholders to participate in the swap—thanks to a recent Greek law that retroactively added a collective action clause to existing Greek bonds—but that only comes into effect if 66% of bondholders agree to the swap.

And even that alternative carries its own risk, since turning what is still (technically) a voluntary exchange into a compelled swap might trigger the credit-default swaps some investors have bought to protect against a Greek default. That’s scary, since no one can be certain that some weak hand doesn’t hold so big a net position in these derivatives that it might be unable to pay off if credit-default swaps were activated.

Still, that might not be what the financial system fears most. If Greece does declare the collective action clause on its bonds, the International Derivatives Association—the group that decides when credit events trigger credit-default swap payouts—could still decide that even this event isn’t enough to warrant pulling the trigger.

That, the fear goes, would call into question the entire system of laying off risk through credit-default swaps—what good is insurance that never pays off?—and might lead to a massive repricing of the risky debt of countries such as Portugal and, shudder, Italy. (Need I say that the repricing wouldn’t be upward?)

Investors will know by the end of business on Thursday what level of participation the Greek debt swap has produced. That will either put an end to these worries or send the markets off into worse fears.

Thursday will also bring new weekly figures on US initial claims for unemployment. And that will set up Friday’s jobs number in the US. Friday also brings the February inflation number from China, which is important as an indicator of likely monetary loosening from the People’s Bank.

If the US jobs number comes in above 200,000 new jobs created in February (or better yet, something close to the 243,000 jobs created in January), and the unemployment rate stays near January’s 8.3%, that will remove some of the fear of a global economic slowdown engendered by China’s announcement yesterday that it was lowering its 2012 growth target from 8% to 7.5%.

All this news hits the market at a vulnerable moment. In recent weeks, US stocks have moved from being overbought—and hence a candidate for a correction—to showing worrying signs that the rally was narrowing, as small- and mid-cap indexes started to lag the market’s biggest of big caps.

In the last week or so, technology—an important leadership sector in any rally—has started to underperform. The financial sector, another leadership sector, has turned flat.

All these technical signs have made investors nervous enough that the negative news flow of the last few days has easily pushed the market into a decline. Now we’ll have to wait until the end of the week to see if we get news good enough to limit the damage to that of the last few days.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Polypore International as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.

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