Forget Greece and Spain, Focus on Italy
Italy may be the next country to severely breakdown unless conditions with credit markets improve dramatically soon.
-- Ansel Adams
With market volatility remaining and the "crash" risk I have been writing about (due to the breakdown in credit spreads that signal that an "event" may be here), the media is continuously focusing on Greece (GREK) and Spain. I say forget all that – Italy may begin to flare up again. Monti's approval ratings have dropped significantly in recent weeks, as bond yields remains elevated above 5.5%. Meanwhile, Italy's markets have gone round trip, sending stocks down to October 2011 levels.
Take a look below at the price ratio of the iShares Italy ETF (EWI) relative to the iShares Spain ETF (EWP). As a reminder, a rising price ratio means the numerator/EWI is outpeforming (up more/down less) the denominator/EWP. A falling ratio means the opposite.
I've annotated the chart to show what appears to be a "rounding top" in the ratio of Italy to Spain, which may signal that Italy is set to significantly underperform the badly beaten down Spanish market. This should make sense given how severe the decline has been in EWP in the past few months. Much of that selling may be exhausted, making the potential for a V-like formation in absolute terms result in Spain performing very strongly, or market participants focusing in on Italy as the next country to breakdown as deflation fears once again grip Europe.
Should the "crash" risk be averted, I maintain that Spain could be a profitable long position given how severely depressed its stocks have been. However, I suspect that a more serious sell-off from already oversold levels may result in Italy dropping at a much faster pace than what's been experienced so far as the euro crisis reaches a fever pitch.
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