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Euro, China, Banks Make Up Key Market Barometer

Monday, 24 May 2010 | 12:22 PM ET

The Euro, Chinese stocks and U.S. financial shares have become a reliable leading indicator of the overall U.S. stock market by embodying the biggest worries among investors today.

A breakout or breakdown in these triple threats to our economy may in fact signal whether the recent sell-off is just a correction or a new bear market.

“The primary cause of the recent market weakness is concerns that the European sovereign debt problems will morph into another global economic downturn,” wrote William Stone, PNC Chief Investment Strategist, in a note to clients. “Uncertainty regarding the impact of Financial Reform Bill, the legal situation at various Wall Street firms, most notably Goldman Sachs, and fears about China’s fiscal tightening” are the other big concerns.

Falling like dominos, the CurrencyShares Euro Trust hit its high for the year on Jan. 13, followed by the iShares FTSE/Zinhua China 25 Index on April 9, and the Financial Select Sector SPDR on April 15. Seven trading days later, the S&P 500 would hit its high for the year and then go on to fall as much as 12 percent.

In an encouraging sign for believers in this barometer, the Euro ETF bottomed on May 18 and is up a little more than one percent since then. Also, the China ETF rebounded today from its 2010 bottom on Friday as concerns about further China tightening eased. But both the financial ETF and the S&P 500 are lower yet again.

The Euro rebound may be the most reliable signal of better times ahead.

“The ongoing struggles in Europe have convinced many investors that a potential Greek default would be a harbinger of a global economic meltdown,” wrote Brian Belski, Oppenheimer Chief Investment Strategist, who compares this situation to the Russian default crisis of 1998. “During that period, the S&P 500 lost close to 20 percent following the default. Fortunately, markets recovered rather quickly, and patient investors were ultimately rewarded. We believe similar patterns could prevail. ”

Fears that regulatory policy will be too restrictive on the profitability of financials weighed on the group again.

“While regulatory risk is (hopefully) reaching a peak, it does create the specter of an overhang for some time,” wrote Richard Ramsden, a Goldman Sachs banking analyst.

For the best market insight, catch 'Fast Money' each night at 5pm ET on CNBC.

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