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Stock markets are rebounding form the recent lows, sentiment is changing from bearish to bullish. That was expected because the decline has stopped. Declining prices fuel bearish sentiment, so when the market goes sideways or rally for an extended period of time, bearish sentiment will recede and bullish sentiment will return.
We could see this change happening yesterday when markets ignored some bearish developments like the departure of Gary Cohn and some bearish inflation data. When Gary Cohn resigned markets plunged but yesterday they rallied, the S&P 500 is back where it was before the Gary Cohn announcement. And yesterday we learned that unit labor costs in the US rose to 2.5%, much higher than 2.1% predicted by analysts. It means businesses are spending more on labour, higher costs means higher prices (if they keep the same margin), this is inflationary.
This may be good for the dollar in short term (people think interest rate will have to go up and this is why the dollar rallied yesterday) but it is bearish long term. Inflation will erode the dollar purchasing power. You will recall that rising inflation is bad for bond holders, as a result bond will go down, yields will go up and the stock market does not like higher yields, the stock market will go down. As a large proportion of bonds are held by China, Japan and other countries, the foreigners will lose on the exchange rate, they will have to sell dollars to get their money back. A wave of selling in the dollar has yet to come.
The markets are not taking Cohn’s resignation seriously, I think there are still too many people who know only one thing, that is to buy the dip. They have grown up during the bull market, they have never encountered a bear market, they think trading stocks is easy, you just buy the dip. It is easy in a bull market I agree, but this bull market is over. The party is over, the bond market and the dollar are going to burst the stock market bubble. The implication of Cohn’s resignation is a trade war, I believe. Trump wants a trade war because he thinks it will be good for America. We can expect Trump to announce more tariffs on imported goods. The dollar was already in a collapsing mode, a trade war will intensify the decline of the dollar. This will push GBP/USD and bond yields sharply higher in the next few months.
I suspect the FTSE 100 is anticipating all this as always, this is why wave 2 in the FTSE is not large as it should be. I mentioned many times that the FTSE leads the way, when the FTSE does not follow the S&P higher you can bet that the S&P will turn down to catch up with the FTSE. Well, based on the above scenario where bonds and the dollar collapse, the UK index is leading the way because stocks will be trading significantly lower in the next few months. The S&P is rallying but the FTSE is lagging. The S&P has already retraced 75% of its January-February decline but the FTSE has only retraced a little bit less than 38% of its decline.
The January-February decline was the first wave of an impulse wave down marking the start of the bear market. This decline will be in five waves, we are now in the second wave up [wave 2]. The question is, where will wave 2 end? We have two possible scenarios in the short term. Either wave 2 is already complete at 7326 [black wave count] or wave 2 will end near 7400 [red wave count] before the next leg down of the bear market starts.
Most likely scenario: 7326 is the top of wave 2, but this second wave is very short. Normally a second wave retraces a larger portion of the first wave. I think 7326 is the top because it is hard to believe the FTSE can rise above that level given the headwinds it will face from the rising GBP/USD and rising bond yields. Therefore I suspect the current rally will end soon and below 7300. In this scenario we are in wave 3 down in five waves [i,ii,iii,iv,v (circle)], wave i (circle) ended at 7062, the current rally is wave ii (circle) expected to end near 7250.
Alternate scenario: because wave 2 is short, it is possible wave 2 is not complete. May be wave 2 is taking the shape of an expanded flat [a,b,c (circle)] in red on the chart. In an expanded flat wave b (circle) will end at new low which it did. The current rally is wave c (circle) inside wave 2 and the target is near 7400. This is the low probability scenario. Either way after wave 2 the FTSE will collapse into wave 3 down.
Thierry Laduguie is Trading Strategist at www.e-yield.com
