Battered Euro stock markets offer investors minimal upside

EUROZONE equities have begun the fourth quarter firmly on the back foot with markets yesterday tumbling for the sixth consecutive trading session – the longest run of losses since January 2009.

Fears that the US will plunge into a double-dip recession have outweighed more positive European economic data and upbeat expectations for the third quarter earnings season. Consequently, the markets are ignoring fresh upbeat European economic indicators and remain decidedly bearish about the prospects for Eurozone equity indices heading into the final three months of 2010.

This is perhaps unsurprising, given the renewed concerns about the banking sector in the wake of Anglo Irish Bank and the surging yields on peripheral Eurozone sovereign debt. Contracts for difference (CFD) traders may well be tempted to take advantage of this prevailing negative sentiment and invest in European stock indices.

However, investors should remember that while the bloc only has one currency, it has 16 different stock markets that reflect the diversity of performance and economic strength across the region.

Trading the indices will protect you from the risks of investing in a single stock but traders would be well advised to pick their equity markets carefully. After all, the German Dax 30 is going to be rather different to the Greek AEX and the Irish ISEQ.

The most frequently traded Eurozone single country stock markets are the blue-chip Dax 30 and the French Cac 40, which have both been stuck in their respective trading ranges since the start of the summer. The more volatile Dax is fluctuating between 5,800 and 6,300 while the Cac is stuck trading between 3,400 and 3,800.

With its bias towards technology stocks, the Dax behaves much like the European Nasdaq, says ETX Capital’s Manoj Ladwa. CFD traders should be looking to make the most of the range trading while it holds.

DOWNSIDE BREAK

Although the Dax is likely to outperform the French Cac thanks to the relative strong position of the German economy, a bullish position on the German blue-chip may not be such a good idea. Ladwa warns that the third quarter earnings season, which starts in earnest on 18 October, could provide the catalyst for a break to the downside in the Dax, given that the market has already factored in a lot of upside and the index is currently trading towards the top of its range.

The other big Eurozone stock market is the Spanish Ibex 35. Despite the dismal economic situation, Spanish equities managed to bounce in the third quarter. But Charles Stanley’s Tony Shepard says that this could simply be a dead cat bounce since the economy looks very vulnerable to slipping back into a recession as recent retail sales and industrial production have been weak.

Ladwa suggests that the more risk averse CFD trader could hedge her bets by doing a pairs trade. For example, if you think that Germany is going to outperform, then you could go long on the Dax and short the Irish index at the same time. Alternatively you could hedge your short Ibex trade with a long position on the Eurostoxx 50, which is a European-wide market.

However, the risk with this trade is that events in the periphery aren’t quite as bad as feared while things don’t turn out so well for the German market, warns Ladwa.

With an upbeat earnings season already priced in and continued fears about economic recovery in the periphery, CFD traders should make sure that they place their stop losses carefully and be ready to cut their losses should they materialise.