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At the start of the year I warned that the FTSE 100 would go down to 5,000 by the end of the year. Given the devaluation of the pound following Brexit and improved economic activity in the US and China during the second quarter, this forecast is still valid but it may take longer for the FTSE to get to that level. Nothing has changed in the long term and I expect my target to be hit in 2017. In the short term however, we will see a larger than previously thought counter trend rally, in time and magnitude. The bottom line is, the collapse in the stock market has been delayed.
Negative developments to watch:
Central banks are running out of ammunitions, an unprecedented wave of stimulus / quantitative easing around the world has failed to put the global economy on a firm footing. It seems Europe and the US are going to experience what Japan experienced at the end of the 90’s, a deflationary cycle that could last many years. The International Monetary Fund warned “The UK’s vote for Brexit has added significant uncertainty to an already fragile global recovery”.
The Japanese stock market peaked in 1989 and is down 57% in the last 27 years.
Despite multiple interventions by the ECB since the credit crunch of 2008-2009, growth in Europe is still weak. The ECB introduced negative interest rates in 2014 in a desperate move to save the economy, but growth is still weak. Like in Japan the spectre of deflation is real and it’s just a matter of time before deflation spreads to other parts of the world. Already bond yields are at record lows in anticipation of a global crisis.
The slowdown has now spread to the UK. The pound has dropped sharply in the last four weeks since Brexit, and consumer confidence is low. The Bank of England must find a solution to revive the economy but cutting rates is not the answer, this would import inflation. The UK is facing stagflation, a long period of low growth and rising inflation which is negative for the stock market. We can expect asset prices in the UK to deflate including house prices.
Italian banks but also Deutsche Bank are in trouble, another banking crisis looms. Any bank failure would spread to UK and US banks. Lowering interest rates won’t help profits at UK banks, this explains why UK bank shares are trading near their post credit crunch lows. Ask a simple question: why are bank shares going down while the FTSE 100 is going up? This is normal behaviour in a bear market. This time however, banks won’t be too big to fail.
A massive debt bubble in China is about to burst. Remember the debt bubble in 2007? This one is even larger. God knows what will happen if China debt bubble bursts.
Perhaps the most worrying development is the rise of terrorism in the West. A number of incidents have taken place in France, Belgium and the US. Such incidents and if they become more frequent as I suspect, will impact on the economic recovery. An increase in the number of terrorist incidents would cause a contraction in both consumer spending and investment, that would be another drag on the economy.
As you can see, you must wonder why investors are in the mood to buy stocks. Greed is the answer. Sentiment is bullish and there is no alternative with better returns. Well, there is an alternative and it’s called cash but investors are too bullish on stocks to contemplate a cash position. My sentiment indicator has been rising for a while, when it’s rising investors are in bullish mood and when they are in bullish mood they focus on the positive news like stimulus, and ignore the negative developments. As long as they are in bullish mood the FTSE has the potential to move to 7,000 in the next month or two, then it’s the big short. Not the film but the most powerful decline since August 2015. In Elliott wave analysis we call this decline a third wave down, following wave (2) which is the current rally. In a bear market, markets decline in five waves and the next major decline will be the third. It’s also called the recognition phase, when investors finally realise it’s a bear market, they will rush for the exits. Increased participation from sellers will create a longer and more powerful wave down than the first wave that ended in August 2015. This third wave will subdivide into five waves [1,2,3,4,5] which is the structure of an impulse wave in a bear market. At the end of wave 5 the FTSE will be trading near 5,000.
Meanwhile I trade the short term and intraday trends, so it does not matter if the FTSE 100 rallies further before the big drop begins. I will continue to track the short term moves up and down as always with my proprietary indicators and Elliott wave analysis.
Thierry Laduguie is Trading Strategist at www.e-yield.com
