Technicals | Sep 27 2011
By Kathleen Brooks, FOREX.com
Equity markets may have staged a reversal Monday and are moving higher after last week’s rout, but we continue to believe that the medium-term outlook remains weak. The strength of last week’s sell-off was striking on two fronts: 1, that after falling nearly 7% it didn’t stage a recovery by the end of the week, 2, the broad-based nature of the sell-off with all indices moving together, suggesting contagion had taken over in global markets. This suggests a market that has ditched fundamentals and is in panic mode. Correlation analysis shows that since the start of September the positive correlations between markets have risen sharply. For example, at the start of August the German Dix index was moving with the SPX 500 77% of the time, this has jumped to 83% since the start of September. Likewise, the FTSE 100’s correlation has jumped from 79% to 83% in the same time period. The Dix and the FTSE 100 have the strongest positive correlation since the start of the month at 95%.
The performance of the MSCI index is a good illustration of this. This global index is in bear market territory, having fallen more than 20 per cent since the market’s peak in May. The index is down 10 per cent since the start of this month. It is worth comparing this performance with 2008 – the peak of the financial crisis. Back then the market sold off more than 50 per cent from June to December 2008. It then oscillated in a 300 point range before hitting a bottom in March. The stock market carnage lasted for 9 months before recovering, and as all markets fell together, so too did most markets experience a recovery at the same time.
So what does this tell us? 1, we could be a long way from the bottom, 2 that stock indices may move together for some time. What could fuel a market recovery? It will likely take an improvement in the European sovereign debt crisis, or signs that the global economic slowdown in not as severe as originally thought for the markets to recover.
Of course whether we do see a protracted period of weakness for stocks depends on if we get a disorderly default of Greece that sparks a banking collapse that dwarves the 2008 financial crisis. At this juncture we know that this crisis has the potential to be bigger than 2008 as sovereign defaults haven’t occurred for more than 60 years in the West. However, if policy makers could come up with a stabilising mechanism to protect Europe’s weakest members then we may step back from the abyss. Markets hate uncertainty, they especially hate political uncertainty. While the debt crisis is controlled by politicians and with no solution as yet in sight, this may be an unfavourable environment for risk for some time yet.
It can be difficult to catch a falling knife and predict a market turn-around after a rout, thus it is worth looking for early warning signals that may help to determine a change in direction for stocks. To do this I have looked at correlations between the SPX 500 index and the gold, the Vix and 10-year US Treasury yields.
Obviously the SPX has the closest negative relationship to the Vix, – Wall Street’s fear gauge, which is priced from SPX options. However, since the start of the summer the US stock market has had a positive correlation with 10-year US Treasury yields. This is because Treasury yields are a good safe haven, and as investors’ fear levels rise they tend to move into US government debt and move out of risky assets like stocks.
Technical Deep Dive:
As mentioned above, the major stock indices are moving together as we start the last week of Q3. Markets are pulling back after becoming deeply oversold last week.
Take a look at the charts below to see some note-worthy levels.
GER 30: After testing the key 5,000 mark this index looks oversold on both a short and longer-term view. The daily chart’s RSI index is below the crucial 30 mark, the MACD is also in negative territory. Added to that the Dax had fallen below its cluster of daily moving averages. It’s not surprising that the index has pulled back today and is up more than 150 points. However, we doubt that the conditions are in place for a sustained rally. 5,325 looks like some stiff resistance this morning. Above here, 5,435 was a previous support zone that is now resistance. 5,000 remains the most important psychological support level.
Dax index: daily chart
ESTX 50: 2,080 and 2,120 are near-term resistance levels, on a very short-term chart the pan European index is looking overbought, so we may see the index fall back towards the 1,990-2,000 mark, which is a key pivot level and should act as a firm support zone.
Eurostoxx – pan European index
UK 100: Although this index is moving in line with global indices, its technical indicators are telling a different story. The daily RSI and MACD are not looking as oversold as some of the other indices, although it has followed the DAX index extremely closely during September. This is something we will be watching closely this week, as this may signal that the UK market has further to fall compared to its counterparts in the Eurozone and US. 5,100 looks like resistance, with 5,000 the key psychological support level.
UK 100 index
JPN 225: This index has taken the cue from Europe and moved in line with global equity markets. We don’t think this will change any time soon since the Japanese economy is so leveraged to the global economic outlook. The yen is rising on the back of safe haven flows; this could also weigh on the index as it may hurt the profits of exporters. Thus it seems unlikely that the Nikkei could rally without an improvement in global economic prospects. Levels to note include: 8,675 then 8,740 – a key pivot. 8,300 remains the bottom for now.
Japan 225 index
The view's expressed are the author's, not FNArena's.
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