FTSE, DOW and S&P 500 at inflection point?

The FTSE has gained around 30% from the March lows, as signs of green shoots lift investor’s expectations of the economy. However, it is struggling to push much beyond this and the question that remains is if the recent falls are merely due to profit taking from the recent recovery or are they the start of a more significant move lower?

Libor, which is the London interbank offered rate for borrowing short term funds in the banking system, provides an excellent barometer of the financial crisis and quantifies the change in sentiment.

Three month dollar Libor has declined for 36 consecutive days, bringing the gap between Libor and the fed funds rate to the lowest level since February 2008. This increase in confidence in the banking system coincides with Tim Geithner, US Treasury Secretary’s latest comments that the US financial system was starting to heal.

The recent rise in equity markets reflects a re-pricing of risk. Fear appears to have subsided and investors have increased their appetite for risk, which is causing equity markets to attempt to consolidate at these elevated levels.

The Vix volatility index, which is a key measure of market expectations of near term volatility, is below 30. This is down from a peak of around 90 in October last year and marks the lowest level since the 12th September 2008, the day before Lehman Brothers filed for bankruptcy.

The rate of recovery has been steep and the recent rise marks the biggest two month move in the past ten years. Minutes from the latest Federal Reserve’s policy meeting indicated that the central bank has reduced its outlook for growth over the next few years and expects higher unemployment and rising prices.

Furthermore, Standard and Poors (S&P), one of the world’s two main ratings organisations, revised its outlook on the UK to negative, but affirmed the country’s AAA credit rating for the time being. Such a downgrade will have a negative impact on international investment in the UK and any further concern could prompt S&P to lower the credit rating, which would massively dent financial stability and our nation’s secure reputation.

Technical analysis of the above chart shows how the index failed to push much above the 200 day exponential moving average (EMA) and the recent selling has caused the medium term upward channel line to be broken more convincingly.

The divergence on the relative strength index (RSI), which is indicated by the RSI declining while the FTSE remained level with its recent highs, shows that the momentum behind the buying is falling. As a result, the medium term arguments are swinging to a more sizeable leg lower ahead.

Initial support is seen at 4300 and a break of this could trigger a further more aggressive move down towards 4000, although the longevity of the recent rally is likely to prevent it getting that low as longer term investors, that missed the previous low, are likely to start buying before it gets there. On the upside, a break above 4500 could initiate a move back up to the medium term resistance at 4640.

In summary, I believe equity markets are through the worst and investors have been re-pricing their attitude to risk, which has caused a prolonged rally in equities. However, perceptions may have got ahead of themselves and the momentum behind the 30% rally appears to be faltering, with further moves lower looking more likely in the short term.

Across the pond the US markets are broadly comparable, although both the DOW and S&P have broken more clearly through their short term bullish trend lines. The moving average convergence divergence (MACD) has also turned significantly lower again, which could indicate a move back to their comparative historic support levels of 8000 on the DOW and 820 on the S&P.