European shares oversold but temptation holds risks

After one of the most vicious global market sell-offs for months, European stocks are ‘oversold.’

At least that’s the term chart analysts use to describe the state of the market after stock selling this week extended beyond certain standardised levels.

The ‘fundamental’ backdrop to this of course is that the world’s stock markets have been falling hard in concert for the whole week.

Commodities (especially base metals) have loomed large, taking a further beating on Friday after a closely watched data release showed the sharpest contraction of Chinese manufacturing activity since 2009.

The apparent end of the ‘high-growth’ phase that prevailed in China at least since 2009, triggered investor flight from riskier assets, like stocks.

This pushed several major equity indices, like the Dow Jones Industrial Average, S&P 500, FTSE 100, Hang Seng and Shanghai Composite to their deepest weekly falls for months, or even years.

Shanghai – New York – Paris – London

One of the gauges used most extensively by specialist technical traders but which has now begun to filter out into wider market awareness is the 200-day moving average.

Regarded as perhaps the most significant moving average on charts using daily intervals, the fact that China’s main stock market, the Dow, S&P, and FTSE 100 have broken through their 200-DMAs is being interpreted as potentially more ominous.

However, from a technical perspective, for markets in Europe, and elsewhere, sentiment (AKA ‘momentum’) indicators like the Relative Strength Index and Stochastic-based gauges have slipped beyond boundaries generally regarded as excessively bearish (please see chart at bottom of page).

Among the region’s broadest indices, the FTSE Eurofirst 300 Index was one of the leaders in being ‘oversold’.

Its RSI had broken the nominal ‘30’ boundary, a level prescribed to depict the fall of an asset below its cost over the preceding averaging period.

Indicators can’t measure absolute value, but at times like these, that’s almost immaterial.

Too far, or not far enough?

The fact that a large swathe of traders has them on their radars gives indicators pragmatic weight.

When markets are ‘oversold’, expectations that they may soon bounce are higher.

Especially when corroborated by other types of indicators, like the ‘Slow Stochastic’ (also pictured).

For the FTSE Eurofirst aggregate, any relief will have to wait for next week, as it joined the further magnification of Europe’s sell-off to close more than 3% lower on Friday.

This took the index through a strong descending trend that has been in place since March.

Whilst bearish, the line has at least contained market falls since then.

It is also being bisected, and therefore perhaps strengthened, by another important marker for traders, a 50% retracement—this one relating to FTSE Eurofirst’s ascent between mid-October and mid-April.

But this is the first time the market has tested the trend line from March since it weakened sharply to fall beneath all major moving averages, 50 (yellow), 100 (dark gold) and 200-day (purple).

Should the trend definitively break, finding another support nearby would be problematic.

61.8% of the FTSE Eurofirst’s ascent between mid-October and mid-April is a fair candidate.

It is about another 3% from the index’s close on Friday.

On the one hand, current ‘over-selling’ argues against a further fall as deep as that.

On the other, common sense and recent experience suggest a higher-than-usual risk that this sell-off isn’t over yet.

Please click image to enlarge