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Stocks: where and why are they most vulnerable?

03 February 2008

Stocks: where and why are they most vulnerable?

The Technical Trader’s view:
We think the European markets are more vulnerable than the S&P and FTSE because they have revealed their relative weakness by having fallen further from their highs and bounced less from their lows...

And in any event, the DJ Euro Stoxx 50 has broken a vital medium-term support from a prior high – and nothing characterizes the solidity of a bull trend more surely that the support of a prior high.

The market has had every opportunity to break back above that Prior High and it has failed. Instead it has consolidated. This may prove to be a Continuation Triangle – only time will tell.

Weekly Bar chart
The market’s powerful bull trend line support has been smashed.

More than that, the market has pulled back through the first major horizontal support from the prior high at 3847 - and there has been no swift recovery.

Look closer.

Weekly Bar chart

There have been a number of small Tops- Double Tops.

The first one perfectly formed, the second rather less so.

But they have established good resistance to rallies above the market.

As has the 3847 support.

Daily Bar chart

The detail of the consolidation beneath the broken support (now resistance) is interesting.

So far it lacks a clear pattern...

It hasn’t completed yet – but we are taking a close interest in the lower diagonal .

And there are interesting pivots at the 3651 and 3530 level.

The Macro Trader’s view:
The Federal Reserve cut interest rates on Tuesday for the 2nd time in 7 days and stocks have failed to respond. Instead of the rally many had expected, they have traded lower and increasingly look like re-testing the lows of 10 days ago.

After 125bp off the Fed funds rate why are traders still bearish? Answer: the economy continues to slow and the evidence is building in the direction of a serious recession. The Fed realized it was behind the curve and in cutting 125bp is trying to get ahead of events and place a floor under the economy.

In truth, they are already too late; monetary policy takes a year to 18 months to take effect, but it’s still better than doing nothing.

The reason for the persistent bearishness is credit market risks remain and are significant. At first concerns centred on sub-prime mortgage defaults, now the fear is centred on the insurance institutions that arrange the insurance cover for all kinds of Bonds.

This is a huge market; 3 times US GDP, and if there is a 2% default that’s a hit to the system of US$720B; more than twice the losses expected from Sub-prime, and that event caused several large US Banks to take huge write downs sending them off in search of new capital injections.

That explains why the S&P looks so soft, but what about the Dow Jones Euro stoxx50? Same argument applies, but unlike the Fed the ECB are reluctant to cut interest rates, they have abandoned their bias for higher interest rates, but with Euro zone inflation at 3.2%; a 14 year high, they are unwilling to act while inflation remains a threat and growth continues to look relatively solid.

But this picture will rapidly change; stock investors see that and are already bearish.

The US and UK are major trading partners of the Euro zone, especially the UK which is their largest export market. With the Euro as strong as it is against the Dollar and Pound and likely to strengthen further against the Dollar, the Euro zone is importing economic weakness.

The Fed has cut because it sees the risks to growth and judges the weak economy will cap and reduce inflation as US generated demand for oil cools; the ECB are unwilling to take that route. They want to see inflation cool before easing policy, but by then the economy will already be in trouble.

The equity traders are ahead of the Central Bank and along with the other leading equity markets, especially the Dow Jones Euro Stoxx50 looks very vulnerable to the downside.

Mark Sturdy
John Lewis
Seven Days Ahead

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