DAX short covering trims losses for European stocks

After yesterday’s sharp sell-off on Wall Street and the follow-up selling in Asia Pacific, which saw the Japanese Nikkei suffer its biggest drop since that Monday August 24, some European stock markets have managed to recover from their initial falls. The German DAX index has turned positive while the UK’s FTSE 100 has trimmed its losses to 0.5%, thanks to a sharp rebound in Glencore shares. Undoubtedly, this small recovery in Europe is due first and foremost to profit-taking from the sellers and possibly some bargain hunting on selected companies. Nevertheless, the path of least resistance remains to the downside for the major global indices and further sharp falls look the more likely outcome in this data-packed week.

Concerns about the health of the global economy are growing each day as more and more data point to an economic slowdown in China, which has weighed heavily on stocks and commodities. The worry is that if the situation deteriorates further then there is very little room to manoeuvre for the major western central banks, with interest rates already being at historically low levels. There is thus a risk that the global economy could fall into a deflationary spiral which would be a disastrous situation obviously. On a micro level, the potential collapse of Glencore could be a big deal, though perhaps not as big as Lehman, for the wider stock markets, while things could also go from bad to worse for German carmakers if more firms are found cheating emissions tests. So there are plenty of factors that could severally impact the already-downbeat market sentiment.

But some emerging market central banks are in a position to loosen their policies further if concerns about waning demand intensify. In fact, India’s central bank has already cut interest rates by 50 basis points to 6.75 per cent today. The People’s Bank of China could be next to loosen its own policy if Thursday’s release of the manufacturing PMIs show further slowdown in activity.

Technical outlook: DAX

As mentioned, we think that profit-taking from the sellers has had a huge part to play in the rebound we have seen this morning, especially as the major indices test some important technical levels. The German DAX, for example, has rebounded from around the key 9325/9400 support area once again. As can be seen from the charts, below, this area was the reaction low that was hit following last month’s sell-off, thus an ideal profit target for the sellers. In addition, a long term bullish trend line cuts through this region, making it a key support zone for traders who like “bottom picking.”

Once it becomes clear which group of traders – the bulls and bears – have the upper hand around the 9325/9400 area, then we could see a significant move in that direction. As things stand, the sellers appear to be in control. After all, the last significant rebound from the 9325/9400 support region ended at the relatively-shallow 38.2% Fibonacci retracement level (around 10500) of the downswing from this year’s record high, suggesting the buyers had lacked conviction in their trades and they therefore booked profit quickly and the sellers held onto their positions. Thus, if the sellers manage to gain control here too then things could turn ugly for the German index fairly quickly as more buyers would rush for the exits. In contrast, if the bulls win control here, they would then also need to break several other resistances such as 9750, 10,000 and 10500 before they grow in confidence and come back in force. So there’s more wood to chop for the bulls than bears.

A decisive break below the abovementioned 9325 level could lead to a big drop because this would be a psychological blow for the bulls and also the fact that there are not much further short-term supports below this level. As a result, the bears may initially target the area around 9000 for this is not only a psychologically-important level but here we also have two Fibonacci levels converging: the 38.2% retracement of the upswing from the post financial crisis low (at 9035/7) with the 127.2% extension of the most recent bounce (at 8995). The 161.8% extension level could be the next bearish target at just below 8580. The long-term key support region is between 8000 and 8160, an area which had been resistance and support in the past, as shown on the weekly chart.