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FTSE 100: Last Move Up Before the Trend Goes Sideways

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The bull run in the S&P 500 and FTSE 100 tenaciously continues but perhaps a time for caution is just around the corner. Based on recent economic reports investor sentiment has reached an extreme level in optimism. Investors are optimistic that the Fed will continue to support and push stock markets higher but the irony is that the economy is beginning to falter at a time when some stock markets are making all-time highs.

If you are a short term bull, I can understand why you would continue to buy at current levels, there is potentially some upside left while sentiment remains resolutely bullish. However, if you are a long term investor, evidence is mounting that upside potential is likely limited. The US economy is deteriorating. Most of the latest economic reports have been worse than expected. Last week’s nonfarm payrolls, PMI manufacturing index, jobless claims and durable goods orders were all weaker than expected. This week theUS pending home sales were also disappointing, suggesting that the US housing recovery has begun to lose momentum. Pending home sales fell by 5.6%, this number was below analysts’ estimates for a small rise. And today consumer confidence fell more than expected.

Oh dear, the Fed’s money printing policy was supposed to boost economic growth and kick-start the economy. Instead it is failing spectacularly. Continued disappointing economic news is disconcerting to the Fed’s policies and should be of concern to investors and traders alike.

This long episode in the stock market history is nearing an end, but it is not easy to predict when the stock market will finally peak and investors will take heed of the warnings. In a market driven by bullish sentiment the stock market can climb a wall of worry for a long time. The end to the bull market will eventually arrive sometime between December and February 2014, but a bear market may not necessarily surface for a while. In fact the chances are that the stock market will go sideways for the next few years.

In the UK it would appear that the long sideways trend has already begun. The FTSE is still trading below its May high, this does not mean it won’t make a new high but if it does it will be short lived as upside is strictly limited. Long term investors should prepare themselves for little-to-no return over the longer term. Short term traders using a non-trend following strategy of buy low, sell high should do well and thrive in this market environment.

So what could cause the stock market to stall?

1.    The stock market rise is not supported by earnings growth.
In a market driven by monetary stimulus, the growth in company’s earnings may not keep up with stock market returns. Something has to give, either earnings growth will accelerate which I sincerely doubt, given the deteriorating conditions or the stock market will decelerate and stall.

2.    Companies are hiding their weaknesses.
Since 2009 interest rates have been so low that companies have been borrowing massively to fund expansion and buy back stocks. This in turn has boosted the value of companies quoted on the stock market. But does this represent fair value? If earnings have been artificially boosted it increases the odds that earnings growth won’t accelerate but decelerate, hence the stock market will need to correct to re-adjust this imbalance.

3.    Some leading sectors like banks are no longer responding to the rally.
This could be the first indication that troubles are brewing on the horizon.

 

 

The UK bank index started to underperform the FTSE 100 index a few years before the financial crisis of 2007 began. Banks collapsed with the general market then perked up during the recovery after 2008, however, the sector’s relative strength as shown by the red line on the chart remains weak. This red line made a new low in 2011 when the FTSE 100 index was in a bull trend, then in 2012 and up to February 2013 banks outperformed the FTSE 100. Since then the relative strength line is down again, an indication that the stock market is about to enter another major correction.

An elevated level of optimism reigns. Is this to do with the Fed policy or with seasonal influence? As we approach the end of October, investors are looking forward to the last two months of the year and the traditional Christmas rally. The period starting in November is generally bullish for stocks, and with the Fed in the background, chances are the market will rally in November-December. But going forward into next year, I’m anticipating that the optimistic mood will change and risk will favour the downside.

Thierry Laduguie is Market Strategist at www.bettertrader.co.uk

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