There is hope on the horizon for bulls after a relentless sell-off last week, prompted by the re-election of Barack Obama as the US President and his continued rhetoric about raising additional taxes of $1.6 trillion over the next 10 years.
Even though Obama has claimed that taxes will be raised only on the wealthy and a large swathe of American taxpayers will not be affected, the markets are not stupid. They feel that the government must eventually tax most Americans to control the fiscal deficit.
The killer for stocks is the upcoming increase in dividend and capital gains taxes. Additionally, all the market hears is talk from the President about tax increases and not much about spending cuts.
The kind of rhetoric coming from the Oval Office has spooked the markets, leading to a sell off.
But the markets don’t move in a straight line and, after a long selloff, they have hit support levels, making a bear rally possible. Support levels are areas where the demand for stocks exceeds demand, leading to a rally in price.
As we mentioned in the earlier week, the Sensex and Nifty continue to form a broadening pattern (Click here for Nifty chart).
The US markets, meanwhile, sliced through multiple levels of support to reach a very strong area of demand. In fact, after a deep selloff on Friday, the US markets ended in positive territory, bouncing from an area of strong support.
A quick note on broadening formations. It is a pattern where price makes lower lows and higher highs, making it difficult to decide where to sell and where to buy without being stopped out. For instance, if one buys at a previous low, the market goes and makes a lower low before going higher, thereby stopping you out. If one buys at the previous high, the market rallies higher before falling, but one gets stopped out again.
Let us take a look at the Nifty chart to see the broadening formation. The two red arrows show the high and the higher high, which would have stopped out the shorts. The blue arrows show lower lows, which would have stopped out bulls expecting a bounce from the previous low. The only way to survive from being stopped out when the price action broadens is to ignore the latest low and latest high in price and instead look for lows and highs which have not been touched by recent price action. Virgin lows and highs have better chance of working when the market is broadening.
Notice that a broadening formation continues with the Nifty making a new low on Friday. The Nifty also entered a gap. It is the small gap shown by a green arrow and a little below that gap is a huge gap. The area of the small gap is shown by the blue horizontal lines and the green horizontal lines show the huge gap area. Gaps are strong areas of support or resistance.
See our previous articles to learn more about gaps. Now that Nifty has reached the gap area, we could see a bounce. The chances of a bounce increase due to the fact that the US markets too bounced on Friday. However, if the Nifty fails to catch a bounce it can head down to the next huge gap level.
Traders and investors should keep an eye on the headlines over the weekend about the fiscal cliff in the US – which is short hand for the simultaneous end of Bush era tax breaks and automatic spending cuts from 1 January – and the new war between Israel and Hamas. Finally, keep an eye on the futures markets in the US as it will have a bearing on the Indian markets. Futures open in the US a few hours before the Indian markets begin trading.
The US markets
In today’s interlinked global economy it is not wise to ignore the US markets. And given the impact of the US fiscal cliff on the global market it would stupid to not look at American equities. Since the fiscal cliff and tax increases on dividends and capital gains came back to the fore after the Obama election the US stock markets have ignored the strong support areas represented by the gaps.
The gaps are shown on the chart (click here for the S&P 500 chart) and you will notice that the markets sliced through many of them. Usually gaps provide a good bounce and continued break of support shows the panic in the US market. However, on Friday the gap at the bottom of the chart held. Also, the fact that politicos claimed they were making progress on fiscal cliff negotiations at the White House also helped.
Unless we hear something very negative on the fiscal cliff front or the war in Israel turns bad we could see the market rally at least for some time. However, if the market continues to fall below the gap where it bounced on Friday, we could see the S&P 500 go down to the support level below.
George Albert is Editor, www.capturetrends.com