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Early this week stock markets resumed their declines after more evidence of a global slowdown emerged following the release of poor German industrial production. In September, markets had been unsettled by weak economic data, the latest news coming from Germany added to the bearish tone. The FTSE 100 is down 5.5% from its September high.
Furthermore a few days ago the IMF cut its global economic growth forecast. We are in a situation where bad news is bad news, this is because sentiment is bearish. Remember, sentiment as indicated by my sentiment indicator (ESI) turned bearish in September. During a period of bearish sentiment investors will sell stocks on weak economic data. This is what I call “bad news is bad news”. Now, there is another situation where “bad news is good news” and this happens when sentiment is bullish.
When sentiment is bullish people will take the bad news as good news, for example if the economy is weak people will anticipate lower interest rates and this is good news so they will buy stocks. Basically when sentiment is bullish investors interpret the news differently, if the news is bad and they are bullish they will find an excuse to buy and the market will rally.
So the real reason why markets are falling is because sentiment is bearish. The consensus is that there is no reason to buy, however, downside risk in the near term is limited. The FTSE 100 is near a bottom which is wave 1 on the chart. Sometime next week the FTSE will find a bottom and a new rally will start.
After a sharp fall investors are attracted by lower valuations. A rush to buy produces some counter trend rallies of various proportions. In the case of a second wave which is wave 2 on the chart, the rally should retrace a large portion of wave 1. Some second waves can retrace 100% of the first wave but in the current set up the maximum target is near 6750.
Last night stock markets in the US soared after the Federal Reserve reassured investors. The Fed is still in no hurry to raise rates and this comes at a time when the economy is weakening. A series of soft economic reports have given the Fed a wait and see attitude. The declining stock market will not help the economy, if a bear market is underway, economic indicators will weaken further. Meanwhile a rally accompanied by bearish sentiment is a signal to sell. Hopefully the index will move higher before it becomes a strong sell.
Thierry Laduguie is Trading Strategist at www.bettertrader.co.uk
