Idea of the day Why stocks are still the main story in Q4

What: Global stock markets are starting the fourth quarter in a strong position. The MSCI all-country index expanded for a sixth consecutive quarter in Q3 and volatility indices remain subdued. Due to the inverse correlation between stocks and volatility (see chart 1), when volatility remains low, this can suggest further gains for stock markets.

How: Of course, volatility doesn’t stay low forever, and investors need to be aware of any sudden surge, but if Q4 follows Q3, then investors’ may show a fairly sanguine attitude to geopolitical risk as long as the global economy keeps expanding and global central banks maintain their bias to tighten policy, albeit at a slow and gradual pace.

It can be scary to buy at the top, for example European cyclicals are outperforming defensive stocks at their fastest rate since 2011, which suggests that Q4 is all about timing. If you sell too early just because stocks are at their peak, even though other signals are telling you that markets still look strong, you risk losing out.

We marginally favour European stocks over US stocks due to a slight discount in valuations, although that is likely to be eroded at some point this quarter. Out of the European indices, we prefer the Dax for the following reasons:  

• Its cheaper valuation compared to other European indices.
• Relative political stability now that Merkel is likely to lead the next coalition government.
• Strong economic growth, German manufacturing PMI for September was confirmed at 60.6, stronger than the rest of Europe, US and the UK.
• The recent moderation in the euro has further to go in our view, as the ECB tread cautiously when considering removing stimulus due to weak inflation. The Dax and the euro have an inverse correlation, so a weak euro is good news for the Dax.

However, we also believe that you need to watch the technical indicators when it comes to trading the Dax at these high levels. As you can see in chart 2, the candle pattern so far today does not look too promising. It is resembling a shooting star, which can presage a downtrend at current elevated levels. We need to wait for today’s market close before we can confirm, however, if it is a shooting star, which happens when the market tries to push the price higher only to find a dearth of sellers, then it is a clear bearish signal and we should wait for a pullback before entering a long position.

We believe that any pullback will be temporary due to the solid fundamentals supporting the Dax, as mentioned above. If we do see a pullback in the Dax in the short term then a key support level that could attract significant buying interest includes 12,507, the 38.2% retracement of the late August low to the recent high.

Chart 1:

Source: Bloomberg and City Index

Chart 2:

Source: Bloomberg and City Index