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European Stocks Ripe for a Correction


It's time for investors to get defensive.

One of the crucial steps toward becoming a successful trader or investor is learning to evaluate opportunity in conjunction with risk. A novice sees only opportunity. It takes experience to know when to step out or stay out of a trade and wait for the next chance. If you have been holding a long position in broad US or European equities, you should congratulate yourself for catching a remarkably strong rally that has lasted several months longer than we thought it would. You also should consider taking profits. In this article, we show how European stock indices are signaling that it is time to exit. In previous articles here and on our website, we have highlighted similar developments in US markets.

In April 2013, we noted that the Euro Stoxx 50 Index had run into resistance near the 2,700 level. We expected a decline from that point, although there was not yet enough confirmation for a short trade. (A key support had not been taken out, and it ended up staying intact.) We believed the markets during the past year were at too much risk of exhaustion to justify long trades, although we have recommended and taken long trades on relatively small time frames. After the almost year-long rally from there, price is reaching another important area of resistance.

The monthly Euro Stoxx 50 chart below displays two exhaustion signals that deserve special attention. First, the "butterfly" pattern tool developed by Bryce Gilmore and Larry Pesavento puts targets nearby, based on the major price swings since the 2007 market high. Second, the "nine-five" exhaustion indicator from Wave59 software registered a signal last month. On the monthly time frame, the "nine-five" has a good track record. It put in a similar exhaustion signal, in the opposite direction, just prior to the end of the big decline at the beginning of 2010.

The London FTSE also is meeting important resistance. On the weekly time frame shown below, price has reached a 1x1 measurement from the 2009 market low, and it is now testing a supporting trend line. If that trend line breaks, then traders should be poised to take advantage of a downward correction at the very least. Even if this does not turn into a major move down (which it can), a retrace to the 38.2% level of the last swing wouldn't be unusual. That would put the first major support at 5,855. Note also that negative divergence is developing between price and the CCI momentum indicator.

Analysis of another European index, the German DAX (INDEXDB:DAX), can be found at Trading On The Mark.

The important message for traders and investors alike is that risk in long positions has increased considerably. Prudent investors will step aside and wait, while some aggressive traders may begin watching for opportunities for brief short trades.

This article originally appeared on Trading on the Mark.
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