(By Tom) Last week was truly one of the most volatile weeks of trading I've seen in my entire career. Early in the week, things looked grim. Spanish 10-year bond yields were at record highs, Italian 10-year bond yields were at highs for 2012, and the Spanish province of Valencia had just requested aid from the Spanish government, worsening their fiscal situation.
To boot, reports from Greece were that they were way behind in their efforts to reduce their deficits. And it was almost a certainty they were going to miss this and next year's deficit targets, and potentially need another bailout or loan forgiveness.
The S&P 500 was sitting on very important support at the 1,330 level, and appeared to be teetering on the brink of collapsing through that support and heading straight to 1,300. It looked as though the market was finally going to be brought down by the weight of Europe, as once again the European mess had reached crisis proportions.
Then, Thursday morning, ECB Chief Mario Draghi said during what was supposed to be a relatively unimportant speech in London, that the ECB would do whatever it took to save the euro, and that their actions "would be enough." The market turned on a dime. And shorts that were emboldened by the previous day's weakness rushed to cover. The market rallied big on Thursday, and continued to move higher on Friday.
Clearly we know that a lot of last week's rally was short covering from traders and portfolio managers who thought that markets were about to move sharply lower. And there were signs of weakness with the rally …
First, it was mostly ETF-driven, and there wasn't as much action in single stocks. That's a sign that large investors don't "trust' the rally, and instead prefer to trade it, rather than re-allocating large amounts of capital and getting "more long."
Second, the macro economically sensitive sectors underperformed. The Nasdaq and the Russell 2000, sectors that outperform during bull markets, lagged the Dow and S&P 500 last week. Even on a sector level, there were reasons for caution …
Sectors like materials, miners and energy underperformed, while safety sectors like utilities and telecom led the advance.
There was one move in markets, however, that needs to be pointed out, as it is a potential positive for the stock and commodity markets …
Treasuries Shot Up …
Then Came Tumbling Down!
Treasury bonds completed what is known to technicians as a "weekly outside reversal." That means Treasury bonds made a new, 52-week high last Wednesday, but finished the week lower thanks to Friday's big decline. You can see this in the chart below.
Outside reversals are powerful technical indicators, and can signal a trend change in markets.
The reason for the big weakness in bonds Monday wasn't readily apparent. But we have to remember that money from Europe has flowed into Treasury bonds as a safe haven — not because Treasury bonds are such a great investment. European investors who have bought Treasury bonds over the past few months are more worried about return of their capital rather than a return on their capital.
However, if ECB Chief Draghi's comments from last week truly usher in a "game changing" policy response from European officials, then maybe the bond market is already anticipating it, and money that had flowed into the bond market from Europe for protection, is now flowing back out.
There is no question the bond market is incredibly overvalued, and a decline will happen at some point. But like the housing bubble, there's no telling when it will happen. When it does, it'll be a big trend change and could present you with a huge opportunity.
One way you could profit from a decline in bonds is through the Proshares Ultra Short 20+ Year Treasury (TBT). This inverse ETF is meant to rise 2 percent for each 1 percent drop in long-term Treasury bond prices.
As contrarians, we must always be looking for signs of a change, and get exposure to it before the crowd becomes aware. It's not clear that the trend change in bonds has occurred. But last week sent a strong signal, one we should all continue to watch closely.
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