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Sideways Consolidation Before The Next Downleg?

 October 10, 2011 10:56 AM

Last week featured some very volatile market action. Equities remained highly sensitive to news flow and rallied on stories that the French and Germans were putting together plans to recapitalize banks (finally). Then on Friday, you had the rally in the morning thanks to the better than expected non-farm payroll release and then the fade when Italy, Spain and a number of U.K. banks got downgraded.

What's going on?

My interpretation is that the stock market had fallen too far too fast and it's now due for a multi-week period of sideways consolidation. The problems in Europe haven't gone away, nor has the threat of an American recession, which appears to be inevitable. As we move through 3Q earnings season in the next few weeks, the markets likely to be range-bound and volatile - until the news flow worsens, which I believe will occur in about one or two months.

Market recap
I recently wrote about what the bulls need to do to take control and the bulls have achieved many of those objectives. The stock market rallied through its downtrend line, though considerable overhead resistance awaits. The technical picture spells stalemate, or a range-bound market in the near term. The bulls have managed to contain the damage and make a goal line stand, but they need to show more to win the game.

The rally through the downtrend is even more evident in the broader NYSE Composite

...and in the Euro STOXX 50, which has been the source of much market angst:

Cyclicals are behaving a bit better as they showed a similar pattern of rallying through a relative downtrend:

I had written before about my concerns about the banking sector. It is interesting to see that the regional banks have rallied through a short-term relative downtrend, though the longer term relative downtrend remains intact. In addition, this group remains below a multi-year relative support level that was violated in August (and now represents resistance).

How to interpret these conditions? Here is the take from a guest blogger on Slope of Hope that studied previous stances of support violations and subsequent market rallies (emphasis added):
Two things I want to draw your attention to in all three of these charts are MINOR violations of established lows ESPECIALLY when followed by sharp reversals and the level of volume.  In each chart, following a sharp decline, we usually see a consolidation period lasting approximately two months at which time a minor break and recovery occurs (of course, sometimes a major break occurs such as in Nov 2008, but I'm talking about minor breaks followed by quick reversals).  Usually, a positive divergence also forms in the RSI and MACD indicators (which only means the trend is shallower).  At this point, we either see a rally or another leg down.
Given the negative news backdrop of an inevitable Greek default and imminent U.S. recession, my base case scenario still calls for another down leg after a period of sideways consolidation.

Europe can't muddle through
I have come to the conclusion that most of the market is too short-term focused and doesn't really care or even want to understand the seriousness of the problems in Europe. Consider this interview with Satyajit Das. His best line was, "A orderly default is like an orderly car crash at 120mph". Right now, the Eurocrats are trying to install the airbags just before the crash and the markets are fixated on every one of their moves.

Over the next few weeks, there are likely to be some positive headlines out of Europe. The EU will likely acquiesce and give Greece the next tranche of aid in order to buy a few more weeks of time. France and Germany are finally trying to put together a plan to recapitalize banks. Barrosso at the European Commission has confirmed the work behind the scenes by making noises about recapitalization plans. However, there will no doubt be all sorts of squabbles about the scope of the plan and its details, as shown by Sunday's Merkozy non-statement of "we will do everything we can to support the banks" when it was evident that there were considerable divisions going into the meeting.

As you watch the headlines, don't forget the ultimate endgame. Greece is going to default. It's just a question of when and how. HSBC has written about the breakup of the euro zone, which was once unthinkable (via FT Alphaville).

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