There have been a lot of questions about whether or not the recovery we have seen in the markets since the Monday/ Tuesday sell off is sustainable. From a fundamental perspective there are two stand out reasons why this rally is not justified:
1, Italy (third largest economy in the currency bloc) is still without a government, it looks increasingly likely it will have to head to the polls once more, which could open old sovereign wounds.
2, The sequester is here, people, and it's happening TOMORROW! This could kick start the US's austerity drive - see what that's done to growth in Europe and the UK...
But the market is not focused on this; instead it's concentrating on all of the liquidity on offer from the world's major central banks. Today Japan's government nominated an uber-dove to be the next BOJ governor, concern from the FOMC minutes that the Fed would start to withdraw stimulus was crushed by Ben Bernanke during his testimony to lawmakers Tuesday and Wednesday when he hinted QE3 isn't going anywhere fast. Even Mario Draghi from the ECB said that monetary policy will remain lose for some time.
This was a green light for the bulls. However, this is a fragile rally because:
1, It depends on the vagaries of central bankers - if they sound dovish then markets are willing to buy, if they sound concerned about excess liquidity the market can sell off. Thus, headline risk is high, and volatility may rise during central bank meetings, the release of minutes and when central bankers are speaking.
2, The reluctant bulls: the rally in the SPX 500 was on fairly thin volume. In fact 100 million more shares turned over during Tuesday's sell off than on Wednesday's recovery.
What should traders do from here?
When the fundamentals are this erratic it's worth turning to price action. As you can see in the charts below, the SPX 500 and the ESTX 50 both have clearly defined ranges. In the SPX 500 1,530 is a tweezer top that could thwart any rallies. 1,480 is short term support.
In the Eurostoxx 50 index, a bullish harami pattern (bullish reversal pattern) at 2,565 should act as solid short term support - and could attract buyers if we get another round of panicked selling.
Another factor that highlights investors' nervousness, although stock markets are rallying back to multi-year highs, we haven't seen a similar sell off in safe havens like the dollar, gold and US Treasuries, suggesting that investors are not throwing themselves into this rally, and still want insurance in case things go pear shaped again.
Overall, the rally back to multi-year highs in these indices has been painful and full of set-backs, however, as long as central banks continue to drip feed liquidity into the markets we expect any sell offs to be fairly shallow. If you trade stocks, it won't be an easy ride to the top from here, so make sure you're strapped into your seat.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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