Why the Australian Stock Market Could Fall 400 Points in ‘Weeks’.
US earning season kicked off last night.
And it could be one of the most important we’ve seen in a while.
The stock market has rallied strongly for months on the back of money printing, while economic figures have languished.
At some point the reality of company earnings must meet the fantasy of money printing.
The US equity market is struggling to find any traction post QE3, and is now trading below the level it was trading at prior to the announcement of QE3. That’s an ominous sign…
As I said a few weeks ago:
‘If the spell is broken on the money printing voodoo there is a long way for the market to fall and I think the announcement of QEternity, as its becoming known, at multi-year highs for the stock market smacks of desperation. If the market continues to fall from here there is not much Bernanke can do because he has already shown his hand.’
I still believe the US equity markets are tracing out a topping formation at the moment, and last night’s price action in the States was another nail in the coffin.
If you have a look at the chart (It’s easier to see if you open the above chart in another browser), you will see past examples of false breakouts in the S+P 500. When a market breaks out to new highs it sucks in new buyers and forces traders who are short to cover their positions.
But if the stock market can’t hold above the previous high it can fall dramatically from that point and cause a false breakout.
But by doing this traders are constantly wrong footed and are usually whipped out of their positions before the stock market is ready to have its real move.
If we look at where the S+P 500 is currently you’ll notice that we’re trading above the high made in April this year of 1422. I have been talking about this level for quite a while now and I still believe that a failure below this level could spell some serious trouble for the S+P 500.
The other thing to note is the moving averages (MA). I use the 10 day/35 day moving averages as my definition of the intermediate trend. If you look back at the chart you’ll notice that the 10 day/35 day moving average crossover has been very timely in warning that the trend was changing.
You’ll also notice that after previous false breaks the 10 day MA crossed under the 35 day MA a few days later and from there the market went into a swan dive for the next few months.
There’s no reason why the current situation won’t rhyme this time. In fact I would say that the divergence between the equity market prices and the underlying earnings reality is becoming so stark that the chances of this false break leading to a large fall are rising by the day.
My initial target for the market if this occurs would be the 200 day moving average, which is currently at 1370. That’s a 5% fall from here for starters.
And I don’t think the Australian stock market would escape unscathed if this occurs. In fact I would say that the technical set up in the ASX 200 is just as compelling as the one in the S+P 500.
When I analyse markets I focus on the distributions of price around a ‘point of control’. Basically the market will oscillate around a price and will have a series of false breaks at either edge before deciding which way it wants to go. As I said above this whips out and frustrates traders.
You’ll see quite clearly that the ASX 200 has had three clear distributions of price over the last three years. The points of control are the midpoints of the ranges and the solid blue lines show you the edge of the range.
When the stock market has a false break of the range it will often reverse in an area between 50%-61.8% outside the range (I have included dotted lines showing the area 50%-61.8% outside the range).
I can’t go into the significance of this range too much, because it’s a key part of my proprietary trading system. But what I can tell you is that it’s an important range that far too few traders pay enough attention to.
I’ve also added a circle every time the ASX 200 has reversed in this zone over the past three years. This has happened 10 times at least over this period and we’re now faced with another period where the ASX 200 is testing the level 50% outside the current range.
A failure below that level could see some very sharp falls to 4200 initially and then perhaps to the bottom of the range at 4075.
Basically the stock market is coiled up like a spring trying to break away from the gravity of the point of control at 4200. If the market can’t escape the gravity we will be sucked back to 4200 in a matter of weeks.
When you combine the US and Australian markets technical situation you can see that even though they are very different charts, they both send some pretty serious warning signs.
That further weakness from here could unleash a domino effect which could see markets tumble 5-8% in a short space of time.
That’s why this earnings season in the US is so important. If there are concrete signs that the current economic weakness is feeding through to company bottom lines then it may be the catalyst for a return to reality.
This chart shows the correlation between economic surprises and the equity market:
The correlation has been strong for the past 12 years but the negative surprises we’ve seen for the past few months have not yet materialised into any equity market weakness. That’s due to money printing.
But the warning sign is there. If US companies continue to disappoint the market, looking at this chart, US markets could easily sell off 10-15% to bring the correlation back in line.
Timber!
Murray Dawes
Editor, Slipstream Trader
This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.
