DAX EU stocks surge ahead of ECB

A number of European stock indices have broken out above their recent ranges, most notably Germany’s DAX index which was up a good 1.5% at 10950 at the time of this writing. Sentiment towards European stock markets have turned positive in recent times due, in part, to speculation about a state bailout for Italy’s troubled banking sector, while energy-linked stocks have surged after the OPEC-inspired rally in oil prices, though both crude contracts have struggled so far this week.

In addition, the slumping euro has boosted the appeal of export-oriented stocks. Although the EUR/USD has found some support around the 1.05 handle, I think that over the coming days the exchange rate may start to drift lower again as the divergence between US and European monetary policies grow. The immediate focus will be on the ECB tomorrow. Any hints that the central bank will be extending QE beyond the intended end date of March 2017 should be bad news for the euro, and good for EU stocks. Even if the ECB maintains status quo, the Fed could spark a rally in the dollar next week, which may undermine the EUR/USD and underpin European stocks.

But as far as the DAX is concerned, well it may have gone up too far, too fast. It has left a gap behind which may need to be ‘filled’ before more gains could be seen. Once that is settled, we would expect to see a bounce at the broken old resistance area between 10745 and 10800.

Indeed, the underlying market structure for the DAX is bullish. Up until this week, the German index had been stuck in a relatively tight consolidation range since early August after its impulsive move above a long-term bearish trend line was met with tenacious selling pressure around the 10800 area. The buyers didn’t vanish however as they defended their ground around 10200 area several times. The end result has been a steady bull-bear battle between 10200 and 10800, give or take 100 points or so, which the bulls have won now. In addition to that shallow pullback, the 200-day moving average is trending higher and the index is holding comfortably above it. This is not bearish. Neither is the fact that a few higher lows and higher highs have been formed.

Now that resistance around the 10800 area has been taken out and given the amount of time the DAX had spent in consolidation, the breakout could be vicious due to pent up demand. So we could be talking about significantly higher levels for the DAX in the coming days, but ideally after that gap is filled. Some of the next bullish objectives to watch include 10980, the 61.8% Fibonacci retracement against the all-time high, followed by the range between 11255 and 11400, which was previously resistance. An eventual break above that region would probably pave the way to new all-time highs.

That’s all good in theory. In practice, we may see the index drop back to its existing range below the 10745-10800 support area. If that were to happen, it could lead to a big sell-off this time around as it would invalidate any short-term bullish bias.