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Sentiment is bullish but the wave count is complete and the Top 20 Differential is still overbought. The odds of a pullback in the FTSE 100 have increased. The question is, will the pullback be a short term affair of a long term correction? When the blue chips are overbought they tend to pullback. The Top 20 Differential measures this and right now the blue chips are overbought.
There are signs the rally is tired, stock markets are now at key resistance levels. I suspect once we have gone through half of the US earnings reports the decline will be underway. During the earnings season sellers will be reluctant to sell, however once it becomes clear there is no surprise they will sell. There is also some bad news coming out like Intel saying it would cut 11% of its workforce or 12,000 jobs. On the other hand Johnson & Johnson issued a solid report and Wall Street rallied further. But the rally cannot continue for various reasons, technical and fundamental.
The pace of the rally is too high relative to earnings growth which means price earnings ratios are getting dearer. The S&P 500 is now trading at about 17.8 times expected earnings, the highest level since 2004 according to Thomson Reuters.
The pullback has taken longer than anticipated to materialise, this can happen. I remember during the early part of the bull market of 2009 some of the rallies were intense. But there was a reason, prices were depressed. In this situation the rally can last longer than expected as valuations re-adjust. The same cannot be said this time, in mid February the market was oversold but not depressed. The reason the rally has gone further than expected is because the news has improved, China is doing better, the oil slide has stopped and the earnings reports are not bad. And above all sentiment is still bullish.
You have to remember that after so many years of bull market, the drop from April 2015 to February 2016 is not enough to turn the majority of investors bearish. Most people are still bulls. It will take a bigger decline (the next third wave down) to turn them bearish. Also the rally has gone further than expected because it’s a second wave – wave (2) on the chart. Second waves are powerful, when the second wave of a bear market is underway it feels like a bull market. During that phase people don’t realise it’s a bear market, they buy because they don’t want to miss the next move up.
The realisation it’s a bear market will come with the third wave – wave (3) which we call the recognition phase. We are now at the top of wave (2), this move is complete as the pattern is a running flat [A,B,C] with five waves inside wave C. In the next few days the FTSE may push higher, however that is not required. The next move is the start of a long decline, the bear market is about to resume.
Thierry Laduguie is Trading Strategist at www.bettertrader.co.uk
