From the July 01, 2012 issue of Futures Magazine • Subscribe!

Trading in Europe’s wake

Corrective divergences

These first two charts provide the necessary context to interpret the recent European stock action, starting with this cyclical bull’s second correction in late summer 2011. In “Index comparison: January 2011-March 2012” (below), the 100 base is advanced to the SPX’s interim high in late April 2011. The growing divergence in performances ballooned to different losses in this major selling event.

Once again, France led the way in this correction, falling rather steeply in July 2011 while the other indexes gradually ground lower. Rather ironically given all the focus on European sovereign debt, it was American overspending that sparked most of this correction. The trading day after the first downgrade of U.S. Treasuries in history, the SPX plummeted 6.7% and sucked the world’s markets into a new fear maelstrom.

Provocatively, the SPX bottomed immediately, carving a low that day that would only marginally fail for a single trading day eight weeks later in early October. Given how the SPX was one of the top performers in the cyclical bull before this correction, its resilience was impressive. Interestingly, the FTSE 100 started mirroring it and ignoring the rest of Europe. This relative U.K. strength made some sense given its underperformance in this bull; it didn’t have as far to fall.

As plunging stock markets ramped up fear, traders’ attention quickly drifted from Washington’s unprecedented downgrade to settle back on Europe. Whenever the U.S. stock market is weak, a dynamic emerges that hammers Europe. A weak SPX leads to dollar safe-haven buying, and the rallying dollar weighs on the euro. As the euro falls, traders increasingly get worried about Europe’s festering problems and dump European stocks.

So France and Germany got hit brutally hard in the latest correction. French banks had huge holdings of the sovereign debt of troubled European countries, including Greece. For a couple of weeks during that correction, rumored impending defaults of major French banks were big news in the American financial media, but Germany following suit was less logical.

As “Index comparison: January 2011-March 2012” shows, the DAX mirrored the CAC 40 almost perfectly in the recent correction. German banks were never in trouble, and German sovereign debt was the strongest in Europe. But there were lots of worries that the Eurozone would fracture. If that came to pass, then Germany’s huge export business would be crippled with the rest of Europe.

Likely, the main reason the DAX fell so hard was because it was up so high in its cyclical bull leading into that correction. Markets often exhibit considerable symmetry in major rallies and corrections. The bigger the preceding rally, the more extreme greed becomes, so the bigger the subsequent correction that is necessary to ignite enough fear to fully rebalance sentiment. Thus, Germany plunged.

This led to wildly different correction losses. The FTSE 100 and SPX saw 18.8% and 19.4% retreats, significant but under the classic 20% correction threshold. Meanwhile, the CAC 40 and DAX plummeted 33.1% and 32.6% respectively.

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