Is This the Start Of Another Downward Spiral For ETFs?

[Chart courtesy of MarketWatch.com]

It looks like the deep rooted problems of the Eurozone finally registered with investors as markets tanked after two consecutive days of seemingly unjustified exuberance. The S&P 500 took a 3.67% dive, while major European indices also took a sizeable hit. Nevertheless, Asia somehow finished on the positive side.

The dollar noticeably strengthened against the Euro as Italy’s situation has quickly worsened, appreciating 3 cents to $1.35/Euro. And as an indicator of heightened Eurozone risk triggering a temporary flight to safety, the U.S. 10-year Treasury dropped to yield 1.96%.

However, the most eye popping figure that grabbed my attention was the Volatility Index (VIX), which catapulted 31.59% to 36.16. This was the largest increase since August 8 when the VIX had a 50% pop. As I mentioned yesterday about how quickly we can switch from risk on to risk off and vice versa, we are certainly back into risk on mode as Italy’s debt problems come to the forefront.

The bottom line is that Italy is under incredibly severe financial strain on an order of magnitude that trumps Greece, as its yields soared once again to break above the 7% barrier, a figure that prompted the rest of the PIGS to get bailouts. Although I would hesitate to say that Italy is at risk of default, some sort of debt restructuring might have to take place. The political upheaval with no current succession plan only adds insult to injury.

Persistent financial woes in Europe could result in an en masse move to relatively safe U.S. Treasuries, especially among emerging markets, many of which have significant Eurozone exposure. This would likely enhance the value of our bond ETF positions.

For instance, the SPDR Barclays Long Term Treasury ETF (TLO) had a 1.83% jump. Though extended maturity bond ETFs are susceptible to greater interest rate risk, a wave of pessimism about Europe’s financial stability would make longer duration ETFs prove quite attractive if markets freefall.

Days like today only support my view, which is to maintain a majority allocation in bond ETFs and cash with minimal equity ETF exposure. As I’ve warned over the last couple months, the Eurozone uncertainty isn’t going away any time soon, making downside protection via our trailing sell stop discipline a number one priority for all of us.

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