Could stocks rebound soon?

August 22, 2016

This week saw data from the UK surprise positively and the severally-oversold pound bounced back sharply, while the dollar fell across the board as the Fed watered down rate hike expectations in the minutes of the FOMC’s last meeting and after some weakness in US data was observed, causing the EUR/USD to climb to its best level since 24 June. The Canadian dollar also rallied viciously as crude oil surged into the bull market territory, while the Australian dollar got a temporary lift from better-than-expected Aussie employment figures, although the market quickly realised that it was part-time rather than full-time jobs which made the report appear so bullish at first sight. Meanwhile equity markets weakened after their recent good run of form, possibly due to the impact of profit-taking in these quiet times. While stocks remained weak on Friday, the dollar bounced back sharply and the pound and Canadian dollar slumped on the back of weaker-than-expected data from both nations.

However, with Q2 earnings surprising to the upside in both the US and in Germany, and central bank policy remaining extremely loose across the globe, I remain optimistic about the near-term outlook on stocks and reckon this sell-off is actually healthy as it will allow short-term overbought conditions to unwind, potentially paving the way for fresh buying interest soon. Likewise, the weakness in the US dollar is likely to be temporary as the Fed remains the only major central bank looking to raise rates again at some point down the line. We are stuck in a side-ways range in the FX markets, which means the probability for the Dollar Index to rebound is rising each day that it falls towards the support range. On Friday it did bounce back but this could be temporary as it hasn’t quite reached its range base yet.

Fundamentally, nothing significant has changed and unlikely to change in the early parts of next week when economic data being very light, though we will have the Euro Zone PMIs (Tuesday) and German Ifo (Thursday) to keep us somewhat busy. But at the end of the week, not only do we have the second estimates for UK and US GDP to look forward to, there is also the Jackson Hole Symposium where the focus will be on comments from the Fed chair Janet Yellen. She may for example suggest that a rate increase is coming sooner than what the markets are expecting. This, if seen, would most likely underpin the dollar and undermine buck-denominated precious metals and possibly even stocks. In contrast, if Yellen sounds dovish then we could see further short-term weakness for the dollar and strength for equity markets.

Chart to watch: DAX

In Europe, the chart to watch is the German DAX ahead of next week’s Eurozone PMIs and German Ifo Business Climate, which is an index based a surveyed manufacturers, builders, wholesalers, and retailers. The DAX famously broke out of its consolidation pattern on Tuesday 9 August and quickly ‘filled’ the gap that it had left behind at the start of the year. It appears as though, those breakout traders took advantage of short-term ‘overbought’ conditions (as the momentum indicator RSI traded near 70) and took profit at around the key resistance level of 10745 (which we had highlighted in our previous DAX report – see “DAX finally breaks out of consolidation!” for more).

The DAX is now near the point of origin of that breakout and old resistance zone, around 10365 and 10475. This area could turn into strong support upon a potential retest, leading to the onset of another possible rally. However, if the buyers fail to defend this area, should we ever get there, then this would be a very bearish outcome. But our base case is that the bulls will defend this area and that we could see a potential rebound towards the prior resistance level of 10745 and eventually the long-term 61.8% Fibonacci retracement level at 10980, which is also the projected point D of the ABCD pattern. As a reminder, the DAX has recently broken the neckline of its inverse Head and Shoulders pattern, while the 50-day moving average is set to climb above the 200, a development called a “golden cross.” For some momentum traders, when the moving averages are in this order, they only look for buy rather than sell setups. Thus, the DAX could also find support from this group of market participants.

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