Euro sentiment hits bearish extreme

“Is shorting the euro the new one-way bet?” CNBC’s hyperbolic headline follows the euro’s rapid descent, from $1.39 in May to below $1.27 last week, its lowest level in almost two years.

It's only the start, say strategists. Barclays, with a 12-month price target of $1.10, predicts a "large, multiyear downtrend" and says the euro is "vulnerable to a serious hit"; Societe Generale sees "significant weakness" and says it could fall below $1.10 by 2016; by 2017, says Goldman Sachs, the euro may have fallen to parity against the dollar.

The fundamental case is obvious.

Quantitative easing is winding down in the US, where a rate rise is expected next year.

ECB chief Mario Draghi, in contrast, favours a looser monetary policy and a weaker euro, which will make Europe more competitive and help boost corporate earnings.

However, bearish euro sentiment is already at extremes.

The latest Merrill Lynch monthly fund-manager survey found a record 86 per cent expected the dollar to strengthen against the euro.

At the same time, a quarter said this was already the most crowded trade in global markets.

The dollar index has risen 10 weeks in a row, something unseen in its 43-year history. Short bets against the euro recently hit their highest level since July 2012.

Further declines may well ensue, but the euro will not continue to fall in a straight line, and traders should remember there is no such thing as a one-way bet in markets. Market correction looming? Poor market breadth is one of three reasons why Hayes Martin, of investment consulting outfit Market Extremes, expects a market correction.

MarketWatch's Mark Hulbert, who is known for his statistical analysis of market turning points, reported last week that Martin is also worried by bullish market sentiment and the highest small-cap valuations in 46 years.

This unholy trinity of poor breadth, bullish sentiment and overvaluation has occurred six times since 1970, says Martin.

On average, stocks declined 38 per cent; the smallest drop was 22 per cent.

No bear market occurred without the three warning signs being present, he adds.

However, Martin doesn’t envisage another savage bear market – a “short and sweet” 13-18 per cent S&P 500 decline is more probable, he says, given the Federal Reserve would likely ride to the rescue.

In other words, any decline will likely be more of a concern to traders than investors.

US rally continues to tire The dwindling number of stocks participating in the US rally continues to alarm, with small- and mid-cap stocks "dropping like flies", as Bespoke Investment Group puts it.

Until March, Bespoke notes, the large-cap S&P 500, the mid-cap S&P 400, the small-cap Russell 2000 and the Russell Micro-cap were “trading in lockstep with each other and comfortably in the green for the year”.

The micro-caps and the small-caps were first to fall, while the mid-caps are now stagnating.

The overall US market, as measured by the Russell 3000, is up 8 per cent in 2014. However, the median return for its constituent stocks is just 1.5 per cent.

That's a real concern, and suggests a topping process is in motion. Alibaba, Yahoo and the taxman The easiest way of profiting from the recent Alibaba flotation was to forget about it, and instead buy Yahoo.

No ordinary investor got to buy at Alibaba’s IPO price of $68, with huge demand ensuring it opened for trading at $92.70.

However, Yahoo, as we noted in May, owns a large stake in Alibaba, one accounting for almost its entire market capitalisation.

Traders piled into the stock in July and especially so in the days leading up to the IPO, with shares rising a third in just two months. The sell-off has been swift, however, and Yahoo has quickly fallen from $44 to $38.

Yahoo’s current Alibaba shareholding is worth an estimated $34 per share; it also has billions in cash and a stake in Yahoo Japan worth about $8 billion.

However, Yahoo would be hit for tax if it sold its Alibaba stake, reducing its value to around $21 a share.

Unless the financial engineers can find a way around that, Yahoo's apparent underpricing may persist. Devil's in the dictionary StockTake readers should enjoy Wall Street Journal columnist Jason Zweig's new online Devil's Financial Dictionary.

My favourites? Apology: “A declaration that other people did something wrong and that any resulting harm was caused by circumstances beyond the bank’s control.”

Discount brokerage: “A firm that enables many investors to wreck their own portfolios instead of paying someone else a commission to do it for them.”

Stock market: “A chaotic hive of millions of people who overpay for hope and underpay for value.”