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In general I don’t produce long term forecasts (FTSE 100), there are so many events that can happen in a year, the forecast is likely to be off the mark. I am a short term trader focussing on the next few days / few weeks. However, this year we are approaching the end of an interesting pattern on the FTSE 100, namely an ending diagonal. What makes this pattern interesting is the fact that this ending diagonal is huge, it started in 2003 and will end in 2017. As the name suggests, an ending diagonal is a terminal pattern, terminal because when the pattern ends, prices will retrace all the way to where the pattern started, in this case to the low in 2003. We are looking at a potential move from 7400-7500 to 3250 starting in 2017.
Here we have the ending diagonal pattern in five waves [(1),(2),(3),(4),(5)] contained between two converging trendlines. The upper line currently near 7200 has been broken. This is a common feature called a throw over. While this breakout may appear bullish, it is in fact signalling an end to the rally, basically wave (5) is nearing an end. This does not mean the rally will end now, I think the rally will end in the range 7300-7600.
An ending diagonal is a bearish pattern occurring in the fifth wave of an advance. The stock market moves up in five waves, at the end of the fifth wave the market corrects and a new cycle starts again with a new five-wave advance. Stock markets don’t complete a major reversal pattern without any significant changes in future economic conditions. The pattern is a warning that something is going to change. I expect some kind of bad news in 2017, that is what the pattern is telling us.
What could cause the severe stock market correction?
1. Rising interest rates in the US: when US interest rates rise, the dollar rises and US companies selling overseas get hit by the exchange rate. Valuations drop and stocks drop. Bond yields become more attractive and this prompt investors to sell stocks and bonds and move money into safer assets like deposit accounts. Meanwhile consumers cut down on spending due to higher finance charges and because they have accumulated high levels of debt since the last crisis, many will be unable to meet their obligations. High interest rates and high levels of debt don’t mix well. One reason why the current bull market lasted so long is because interest rates have been so low for so long, there was no alternative except buying stocks. Investors bought stocks mainly for income and this fuelled the stock market rally. This will change as rates rise.
2. Currency war and Yuan depreciation: when a country’s economy loses steam the leaders can engineer a currency devaluation to boost exports. And when the country in question is China, stock markets investors in the UK and the US will be watching closely. In August 2015 stock markets plunged when China devalued the Yuan. China has suffered an economic slowdown, property prices are in a bubble and stocks are going nowhere. It is very likely the Yuan will depreciate further as foreign investors pull money out of China.
3. Bursting of the debt bubble: we thought we had borrowed too much in 2007 when the credit crunch hit. Well, today there is more debt in the world. China’s credit-to-GDP ratio has surged from 127% in 2009 to 180% today, the debt of firms in emerging markets has quadrupled over the last decade and in the US, the federal debt has jumped from 60% of GDP in 2007 to 105% in 2016.
4. Protectionist economic policies: When Trump was elected last year he promised to be tough with China. Well, this kind of attitude can push countries into a trade war which is not the best outcome for the global economy. This is one reason the Yuan will depreciate further, a trade war between the US and China would hit Chinese firms and prompt capital outflows.
Despite the potential problems we face this year the stock market is strong as sentiment is positive. The FTSE closed up again yesterday, this time we saw a reversal into the close. What I mean is that the FTSE did not close near the high of the day. The S&P is struggling to rally to new highs, it looks like the US index is turning down.
The Trump effect has pushed stock markets much higher than I expected. As long as people expect a booming US economy the stock market will continue to advance. Stock markets don’t move up in a straight line, except during short periods of time like the move since before Christmas, this one is in a straight line. The RSI, a momentum indicator, has pushed to a record 81.6 on the daily chart. These are rare events and when they happen they tell us something bullish is happening to the global economy. Not one thing but a combination of factors like increase demand for goods and services, more jobs created, more inflation, more money flowing into stocks…
Meanwhile the stock market bubble as well as the debt bubble are getting bigger, the bubbles will pop but I can’t say when. Predicting the bursting of a bubble is practically impossible. We must go along with the flow until the bubble bursts. I am a short term trader, if I understand what the majority of investors think, I can make money by anticipating what they will do.
Right now the majority of investors are bullish and because the behaviour of the stock market is extremely bullish, this tells me the rally will probably resume after a short term pullback. We’ll probably have a 200-300 pts pullback to relieve the overbought condition. There are always profit takers along the way and new scares, but investors are in bullish mood as I said, we must track the market higher as well as being prepared for a major reversal in 2017.
Thierry Laduguie is Trading Strategist at www.e-yield.com
