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The market moves up in three phases. In general the rally starts on rumours, for example last week the rumour was that the ECB would announce some new measures to boost the economy. On the day of the ECB’s announcement the market rallied again, that was the second phase. The third phase occurs after the news has been digested, this is when the latecomers join the party.
So today, after the long rally of the last few weeks in the US and Europe, investors have digested the good news and are now focussing on valuations. In the UK the FTSE 100 continues to lag other indexes. There is no rally here but a sideways move since mid May. This underperformance is due to the weakness in commodity prices, banks and emerging markets.
A large proportion of stocks in the FTSE 100 are exposed to commodity prices and emerging markets, when commodity prices go down and economic activity in emerging markets slows, these stocks will underperform the market. This explains why the UK index is weak. The thing is, these sectors are weak for a good reason, they are pricing in some bad news going forward, hence the weak price action.
As sentiment is bullish we could see higher prices in the short term but in the next few weeks or few months chances are the FTSE will be trading lower. Some measures of bullish sentiment are already at an extreme, a condition associated with a market top. The 34-day BTI, my own sentiment indicator, is not yet at an extreme but not far away either. A continuation of the rally would push this indicator over the limit in which case it would send a sell signal.
On the chart the high was 6895 set on 15th May. Whilst the S&P 500 and DAX have advanced to new highs the FTSE has gone sideways. The S&P 500 is now overbought and due for a pull back, for this reason and if the FTSE makes a new high, upside will be limited. It is possible to count the recent low at 6795 as wave 4 of a five-wave rally. If wave 4 is over the FTSE will rally to 6920 in the next few days to complete wave 5.
However, we can not turned bullish unless 6895 is broken, so far this level remains intact. That’s because there is an alternate scenario in which wave 4 is not yet over (red arrows on the chart). If wave 4 is not complete, it means the wave is taking a complex shape like a downward triple zigzag. This pattern suggests an immediate decline to 6730 from current levels before the next rally starts.
The bottom line is that we have two scenarios: either the FTSE will decline to 6730 immediately or it will first rally to 6920 and then decline to 6730.
Thierry Laduguie is Trading Strategist at www.bettertrader.co.uk
