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Stocks Rally on Draghi, But How Long Will it Last?

Stocks Rally on Draghi, But How Long Will it Last?

Talking Points:

- The ECB made no changes at their rate decision this morning, but Mr. Mario Draghi did offer a negative assessment on current global economic conditions, with hints towards QE-modifications at the bank’s March meeting.

-The near immediate-response has been support for risk assets and weakness in the Euro, as additional Central Bank support has provided hope to dip-buyers and fear to short-sellers. The big question is how long this ‘risk-on’ rally might last, and the answer to that will tell us how much panic is emanating in the global economy right now.

- Trading in any market is dangerous right now. Volatility is high, which means that your chances of winning in any individual trade is probably lower (higher volatility = increased range of potential outcomes). Risk management is a necessity here. Read our Traits of Successful Traders research to see what has traditionally produced adverse results for traders.

Euro dives as Mario Draghi sets the stage for March: We discussed this after the December ECB meeting in which the bank disappointed markets by not increasing the size of the bank’s QE package, but this recent course of events is not without precedent. When launching QE in 2014, Mr. Draghi first teased markets with the concept of Euro QE in May, with a tip that we may hear something in June. June came and went without any announcement, but a month later in July the ECB announced that they would be launching a program. Given the unique status of the Euro zone, and the fact that one Central Bank manages the monetary policy for 18 individual nation-states, it makes sense that gaining political support for such a program may be more complicated than simply putting it up to an ECB vote.

Well, after initially teasing markets with an increase to the program in October, the ECB failed to deliver in December and instead merely adjusted the deposit rate (allowing the bank to buy more bonds at even lower negative yields), and this morning Mr. Draghi pointed to March for another potential review of the program. The response, at least initially, has been Euro-negative and risk-positive as stock markets are moving up on this increased sense of support from the world’s largest Central Bank.

These comments appear to have been well-received by markets as risk assets put in near-immediate ascension on the prospect of more stimulus out of Europe. The Euro is lower across the board as investors are factoring in the potential for further dilution to the currency after December’s lack of an increase to European QE.

What we know for a fact is that the European economy is facing some very difficult times. By many accounts, the term ‘depression’ can be used for many southern European countries as the recessions there have raged for over 2 years. This has continued for so long that political risk has begun to creep into the engine of European growth and stability in Germany and a raging migrant crisis introduces a whole new slew of risks for investors to contend with.

So, the situation in Europe is not good. Stock prices are still really high by most historical measures, even when including this most recent bout of weakness. But the ECB has options left, and to quote Mr. Draghi from this morning’s press conference: “We have the power, willingness, determination to act.”

That sounds like a Central Banker that isn’t going to let markets collapse without a fight. So what we said in December stands today, and if anything is just further cemented by this recent commentary; but additional European QE is likely just a matter of time.

Created with Marketscope/Trading Station II; prepared by James Stanley

Price action in the DAX has been especially interesting this morning. The statement was met with brisk moves higher as investors factored in the prospect of additional QE out of Europe, but sellers have responded very quickly. On the chart below, we’re looking at the hourly chart in the DAX, and notice how each bear flag that’s been produced over the past two weeks has led to brisk moves lower. This is how you want to try to time down-trends; let prices move up to a point of resistance, and then look to trigger the short so that you can manage your risk. If prices don’t reverse, then eat the stop and look for greener pastures elsewhere. This is one of the most common ways that traders look to offset that Number One Mistake that Traders often make with faulty risk-reward.

Created with Marketscope/Trading Station II; prepared by James Stanley

How long this rally lasts will tell us quite a bit about the next couple of weeks’ worth of price action. Should sellers jump in and take control, moving prices in equity markets to new lows in the coming days, well we have an onslaught of panic and will likely need a more vociferous response from Central Bankers to stem the declines. But should support hold and prices move up, then we may have a ‘slower-developing,’ grinding-type of situation where prices take a more manageable trajectory lower; and we have the potential for some very aggressive strength in the coming days as investors cover short positions along with traders trying to ‘buy the dip’ ahead of more Central Bank action.

The question of weakness isn’t really a question at all at this point, that’s a given. The three risks that we wrote about to cap off 2015 have raged so far this year, and at least at this point, there is no end in sight. A slowdown in Asia is happening, and by most accounts it looks worse than originally expected. Commodity prices are continuing to dive lower, and this could have a severely negative impact on corporate earnings in the coming quarters, and should the damage from a commodity meltdown become bad enough, we may even see lenders become impacted. And much of the world is still struggling with the prospect of four rate hikes out of the United States this year. Policy in the world’s largest economy is getting tighter when much of the world can’t bear it. The one stimulatory impetus for global markets right now is Central Bank action, and as Mr. Draghi reminded us this morning, we haven’t heard the end of this theme just yet.

Chinese stocks lower despite reports of over a Trillion Yuan (~$150 Billion) worth of injections since mid-January: Last night near China’s market open, a piece of news began circulating through markets, and I believe I even received a couple of notifications on my phone on this matter; but it was being widely reported that Chinese regulators have injected ‘the most cash in three years in Open Market Operations.’ This is a bullish signal, or should be; and it was for the first half of the trading session, as the Shanghai Composite marched to new gains ahead of the mid-day break. But after the break, matters got considerably uglier as selling took over and drove prices even further below the 3,000 psychological level that the Shanghai Composite has been struggling to hold this week.

This highlights how this recent bout of panic has begun to take on a life of its own. Once fear hits main street, or the retail market, it can be difficult to slow down. The scares that we had back in August 2015 and previously in October of 2014 were very brief and short-lived; it wasn’t something that was instantly recognizable to investors that just check their monthly statements at the beginning of the month. This rout is beginning to become very noticeable – and price action on the S&P 500 over the past week has been indicating as such. Once those investors open their January statements and see 5-10% haircuts across the board, that can illicit quite a bit more selling, and at that point fundamentals can go out of the window because the market will be driven by emotions rather than logic. This touches on the concept of ‘reflexivity,’ in which Mr. George Soros posits that markets are least efficient after making outsized moves. For Mr. Soros, these situations are opportunity. For much of the rest of the world, these situations are dangerous.

Last week we discussed how Mr. James Bullard, the most hawkish member of the Fed, took a decidedly dovish tone in discussing the impact of lower Oil prices on the Fed’s interest rate expectations. And we’ve also recently heard from the head of the San Francisco Fed, Mr. John Williams, in admitting the the bank was ‘wrong’ in their expectation for lower oil prices to have produced inflation. And despite these claims and assurances stocks have just continued to move lower. Even in a bearish down-trending market, these comments should have offered at the very least some respite in the selling; but they’ve only appeared to make it worse. So price action isn’t moving directly with the news and data, and that would indicate that there is an exogenous driver here, of some kind; and the deeper we get into the year and the further that stock prices fall, the more that exogenous driver looks like increasing fear and panic in the general public, and that’s not good for anyone – even for bears that are already short and stand to profit off of continued chaos.

To be sure, there is a recipe for lower stock prices in markets right now. But moves shouldn’t happen linearly, because if they do there is something very troubling going on, and even if the drivers aren’t all that troubling – the consequences are.

Quite frankly, the world is a tinderbox right now that can catch fire on any of a multiple of fronts and that can create a painful domino effect around-the-globe. Markets are reflecting some of that risk, but should markets ‘break’ or ‘collapse,’ before any of those things actually happen, well falling prices may be the catalyst that sets that tinderbox aflame. Again, when panic and emotions set into a market, price action can take on a life of its own. As economies like Russia and Brazil get squeezed by a strong dollar, rampant inflation and falling petrol prices their range of actionable-options decreases massively. This increases geopolitical risk exponentially as a migrant crisis has enveloped an already politically-vulnerable Europe.

The risks are there, to be sure; but the DAX has fallen -11% already this month, the S&P is down by -9.2%, the Nikkei is down by -14.2%, and China is down a whopping -18.61% in Shanghai (SHCOMP) and -22% in Shenzhen (SZCOMP).

So this isn’t the time that one would want to buy unless they have a really well-heeled reversal strategy that can manage risk really, really efficiently. And further to that point – when mutual fund and 401k investors open their January statements, what do you think those types of return numbers will say to them? It will likely bring more selling. But this is why bear markets take time to develop. Sentiment has to change throughout the market, and we’ve already seen the beginnings of that change as ‘buy the dip’ in US Stocks has turned into ‘sell the rip.’ Surely, some bourses have crossed the litmus into ‘bear market territory,’ but that’s an objective way to look at a subjective thing (sentiment), and the case could be made that bear markets had arrived far earlier than yesterday in the Nikkei. But we’ve also seen panic and fear and prices have moved aggressively lower in a short period of time.

The point of bringing all of this up is to urge caution for traders on both sides of these moves in Global equities (or any risk-asset for that matter). Markets driven by emotions can stay irrational much longer than any one trader can remain solvent, and that’s where we’re at right now. Volatility can increase on both sides of the spread as more decisions than usual are being driven by panic and fear as opposed to logic.

As an example of this, there are some reports this morning that allude to the fact that the Hang Seng is trading below ‘book value,’ after the recent declines. This would make it seem like the Hang Seng is ‘cheap’ or ‘on sale.’ I urge you to take caution with such metrics. Price/book value is historically a horrible predictor of stock prices, because prices are more driven by sentiment and opinion than they are accounting values. During bull markets, earnings are worth more (as should be the same with assets); and during bear markets, they’re worth less. At the end of the day, an asset is only worth what someone will pay you for it at a given point in time (the quickness of which is determined by liquidity), and right now the Hang Seng is dropping like a rock. When we first pointed out this trend-line break back in August of last year, the HKG33 (CFD) was trading at ~22,500. Last night we hit a new low at 18,522. That’s a move of -17.6% in less than half a year. So, again – weakness isn’t really even debateable at this point, that’s here. The question is entry points and whether we’re at the stage where ‘something bigger’ might develop.

But after this morning’s reminder, traders should keep in mind that markets don’t often make linear movements higher or lower. Entry points still matter, and risk management is still a requirement for anyone that wants to speculate on such tenuous matters. If you’d like to brush up that risk management, check out our series on Traits of Successful Traders.

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.