Global Markets Overview – September 23, 2014

The tide turning as small caps slide out

The small global rout overnight will sharpen the focus on market conditions, forward expectations and market participation.

I have consistently followed the statistics in the S&P as a guide for direction, and since November last year US futures have not experienced a pullback of 5% or more. The S&P hasn't experienced a 10% correction in three years - so momentum is still intact.

However, I continue to look forward and there is mounting evidence this is starting to turn. December futures have fallen 1.5% in the past three days and have started today's session in a similar downward fashion. But it's the development in the small cap space that suggests the momentum may be coming to an end, beginning a broader sell-off.

The divergence in the Russel versus S&P is clearly widening and the loss of support in the small cap space is a symptom of broader market concern. The record closing highs have left the market exposed and slowing participation, plus turning market sentiment, is likely to see the tide flowing out of the equity markets in the coming few months. (There is nothing wrong with a pullback, record highs needs to be put in perspective. Equities at this level have had strong wealth creation returns for US and international investors alike.)

US seasonality and the end of the asset purchase programme in October, coupled with speculation of rate hikes and the collapse of cyclical risk instruments - such as copper, iron ore, Brent and Tapis crude, material equities and the AUD - spell trouble for higher highs in equity markets.

The nervousness around equities only strengthens my call that being long the VIX (longer-dated contracts are the ones to watch) is the best way to play the slide in the markets. I also see the small-cap slide continuing as confidence falls out of this space. I'm tactically bearish as the risk trade is pulled and safety trade is bid up. And the clear confirmation of this will be the break in the November 2013 trend in the futures market. Once this is broken, it will signal the broader market is in for a slide as well.

Ahead of the Australian open

There is no getting away from what has happened in the iron ore (IO) market. Overnight, IO fell to US$79.80 a tonne - the lowest level sinceSeptember 2009. What is even more dire for the IO plays is the collapsing price at the 58% Fe level, which is trading at an 18-to-20% discount to this 62% spot price.

The price action in FMG yesterday is very telling, and a clear symptom of the 58% price. The slide has further to go and, despite being bid up in the afternoon, it has 98% China exposure (98% of its revenue comes from China) to a commodity that is capitulating FMG is in for further hurt.

Even more worrying are the high-cost-medium and small-cap plays that are now under water by clear margins. There is going to be further pain in this space and we will see a few more hit the wall inside the next two months.

I also see a very clear trade developing from the international side. 43% of the Australian index is foreign-owned (it was higher in June), and the movements in AUD/USD and AUD/JPY clearly illustrate that profit repatriation is underway. The breakdown in the currency is clear, and Japanese pension and insurance funds have benefited from the uptrend in the banks and yield-trade stocks. This is another trade where I am tactically bearish the yield trade, as this still has plenty of room to be shaken out on international selling.

We're currently calling the ASX 200 down 8 points to 5354. That is two points from wiping out all the gains made in 2014. The ASX did cross this mark yesterday and is likely to test it again today. I wouldn't be surprised, however, to see some support for the banks after they saw 2+% slides yesterday. The short term trend is still to the downside and any positive print today will be pushed down by better exit points from the bears. The ASX is in a perilous position and it does have further risks associated with it.

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