Rare ‘Irrational’ Indicator Sets Up a Trade
Former Federal Reserve Chairman Alan Greenspan may be most remembered for the phrase “irrational exuberance.” In December 2006, he asked if stock prices were too high, saying, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
In time, traders would realize that the exuberance was just beginning when Greenspan spoke, and those who bought PowerShares QQQ Trust (NASDAQ: QQQ) at the time of Greenspan’s comments would have enjoyed profits of more than 500% about three years later. At that time, the exuberance had become irrational and prices crashed.
Now, European Central Bank (ECB) President Mario Draghi is calling markets “irrational.” He recently wrote in the German newsmagazine Die Zeit: “It should be understood that fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area.”
Draghi is committed to fixing the euro and helping Europe survive the debt crisis, and “irrational fears” imply that Draghi believes European stock markets are undervalued. In the day after he made his comments, traders were unimpressed and European stocks sold off slightly.
European bulls can point to low price-to-earnings (P/E) ratios to support their case. An ETF tracking the stock market in Italy, iShares MSCI Italy Index (NYSE: EWI), is trading with a P/E ratio of 9. The ETF for Spanish stocks, iShares MSCI Spain Index (NYSE: EWP), has a P/E ratio of 10. The iShares MSCI France Index (NYSE: EWQ) and iShares MSCI Germany Index (NYSE: EWG) are both trading with a P/E ratio of 11, as is the iShares S&P Europe 350 Index (NYSE: IEV).
Those P/E ratios are low, but they can fall much lower without becoming irrational. Bear markets usually bottom with a single-digit P/E ratio. The all-time low in U.S. markets was a P/E ratio of 5 in December 1918 during World War I. Based on history, there could be up to 50% more downside in European stocks.
Monthly and weekly charts of IEV are shown below. Neither time frame is bullish. The monthly chart is the more interesting of the two, showing a potential double-bottom setting up.
Momentum indicators make it likely the pattern will fail to complete the formation, and a decline to $24.50 could be expected if that happens.
The daily chart is also bearish. The relative strength index (RSI) is shown in the center of the chart below. RSI is most commonly used to determine whether prices are overbought or oversold, but it can also be used to assess whether prices are in an uptrend or a downtrend. When prices are in a downtrend, RSI usually moves between 20 and 60, while it will generally stay within a range of 40 to 80 during an uptrend. In the most recent advance, RSI was unable to break above 60, a bearish indicator.
MACD, shown at the bottom of the daily chart, has also turned down as prices have struggled with short-term resistance during the past few weeks.
Draghi has been attempting to reassure the markets all summer that the ECB will do whatever is necessary to preserve the euro, but European stocks have made little upward progress. This is in contrast to the experience in the United States where assurances from Fed Chairman Ben Bernanke that easy money would remain available have led to sharp up moves in stocks.#-ad_banner-#
Greenspan’s irrational exuberance has become one of the most famous market calls of all time. Contrarians who bought on those comments were well rewarded. Draghi’s irrational fears may also be a trading opportunity for contrarians. In hindsight, this may turn out to be an excellent time to short European stocks.
Shorting IEV at the market is a low-risk trade with a stop-loss at $38.22, about 8% above the recent price, which is where resistance can be seen on the weekly chart. A break above that resistance would be a bullish signal. The monthly chart offers a downside target of $24.50, about 30% below the recent price. That means this trade offers an excellent potential risk/reward ratio of about 3-to-1.
This article originally appearead on TradingAuthority.com: