Trading the index differentials

The incoming head of the FOMC stated during her recent testimony that no asset bubbles are apparent – certainly not in equities – and that removing QE too soon could be detrimental to what is currently a fragile recovery. 

It’s a tad ironic that US indices continued to push higher in the wake of these remarks, posting record highs as the appetite for risk on the promise of continued liquidity emboldened equity investors.

When we look at the chart below, which shows the FTSE 350 mining sector compared to the Euro Stoxx 600, there is a divergence which more than implies that the rise in equity indices is founded on sand rather than solid fundamentals. Demand for base metals, if the economies are improving, either needs to catch up with the index or the index will have to correct to the downside. 

FTSE 350 vs Euro Stoxx 600 chart

Economic data for the UK has been nothing short of impressive recently, and it’s looking likely that the Bank of England will be the first western central bank to tighten monetary policy. However, the stock market is certainly not a true reflection of the underlying economy and when compared to other global indices, in particular the DAX 30 and the Dow Jones, the FTSE 100 has in fact underperformed.

From March 2009 to present, and even in the most recent six months, it is the mining sector – making up a large weighting in the UK benchmark – which continues to make its presence felt: while the DAX has seen gains of 156% since the March 2009 lows, with 17% in the past six months, the FTSE has seen gains of only 93% and just 7% in the past six months. Here we can see that the relative strength of the FTSE is weakened by the nature of its constituents. Furthermore, given recent profit warnings from some of the top mining companies, there is little to suggest that the FTSE will catch up in the near term.

It is useful to examine and more importantly take advantage of these diverging relative strengths of global indices, or the differential, as it were, is through a differential market index.

DAX vs FTSE chart

The FTSE is currently trading at 6675 while the DAX is at 9170, with a difference of 2495. If you think that the FTSE will perform better than the DAX, you could decide to spread bet on the differential market to decrease. If I think the DAX will perform better, then I can speculate on the differential to increase. 

Judging by the one-hour chart, there has been a clear uptrend since the beginning of this month. The differential on the FTSE/DAX is showing a degree of bearish divergence on the RSI, which, coupled with the channel top resistance, means we may be looking for a correction to the downside before the trend continues.

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