More Euro Zone Dominoes to Fall?

05/24/2011 10:41 am EST

Focus: ETFS

Thomas Aspray

, Professional Trader & Analyst

Renewed debt problems in the euro zone have shaken world markets this week, and if the crisis spreads to other nations, there are two in particular that look most vulnerable now.

Rising concerns that Greece would default on its debt obligations spurred selling around the globe on Monday with some of the worst losses sustained in Asian markets. It has been over a year since these debt concerns first surfaced, so many market participants are likely wondering whether Greece’s problems will spread or if they will have any long-lasting effects.

Over the past year, the euro debt crisis has only had a short-term impact on the US markets, as the major averages have soon resumed their overall uptrends. Clearly, Monday’s drop in the US market has done some technical damage, as the short-term bottoming formations discussed last week (see “Market Timing 101”) have now been broken.

The intermediate-term analysis for the stock market is positive, though a test of the April lows at 1294-1302 in the S&P 500 and 12,100-12,200 in the Dow Industrials is a now a greater possibility. Of the major averages, the Dow Jones Transportation Average is still holding above its recent lows.

A technical look at the STOXX 50 average, which is made up of the 50 largest companies in Europe based on market capitalization, can give us some key levels to watch over the next week. There are two European nations that seem to be the most vulnerable if the debt contagion spreads.

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Chart Analysis: The STOXX 50 violated its uptrend from last summer’s lows, line a, in March. The rebound from the lows was quite sharp, but it appears to have failed at the resistance in the 2675 area.

  • Monday’s drop violated the early-May lows and clearly broke the short-term uptrend
  • A break below the April lows at 2554 (line b) would be more negative and suggest a decline to the more important support at 2465, line c. A violation of this support would suggest that a major top had been completed
  • There is initial resistance now at 2610-2625 with more important resistance in the 2650-2675 area. A close above this level would be positive

NEXT: Two Euro Zone Nations on Thin Ice Now

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The downgrade of Italy’s government debt late Friday put further pressure on the euro on Monday, though it is trying to stabilize early Tuesday. The iShares MSCI Italy Index Fund (EWI) gapped through its daily uptrend, line a, on Monday.

  • EWI has next support in the $17 area with longer-term support in the $16.20 area, line b
  • In June 2010, EWI hit a low of $13.21 during the first wave of euro debt crisis selling
  • The daily on-balance volume (OBV) is holding up fairly well, as it is still above support at line c
  • The weekly OBV (not shown) could break support this week if the selling continues
  • The daily chart shows initial resistance in the $18-$18.50 area with stronger resistance above $19.50

The Belgian government has been deadlocked for the past 11 months, and this was the main reason why the nation’s debt outlook was downgraded on Monday. The loss of its AA+ rating could increase the costs of financing its debt. The iShares MSCI Belgium Index Fund (EWK) has retreated sharply from the early-May highs at $15.65.

  • EWK also gapped lower on Monday but is still above the next good support in the $14.10 area, line d
  • There is a good support from $14.10 down to the daily uptrend in the $13.50 area, line e
  • Though the average three-month volume is acceptable at 230,000 shares, the daily chart reflects quite a few peaks and valleys. This makes the daily OBV analysis less reliable.
  • The daily OBV is slightly below its weighted moving average (WMA) but above the May lows
  • The weekly OBV (not shown) is still positive
  • There is chart resistance now in the $14.60-$15.00 area

What It Means: Over the past year, the global equity markets have repeatedly shrugged off new euro zone debt concerns. The failure of the markets to react more significantly may be a short-term positive, but it often takes some time before reality hits.

In the summer of 2007, the collapse of two Bear Stearns hedge funds was the first warning about the mortgage crisis, and the harsh reality did not hit the markets until a year later.

Of these two country-specific ETFs, the iShares MSCI Italy Index Fund (EWI) looks the weakest, and while the iShares MSCI Belgium Index Fund (EWK) is still positive technically, I would avoid both funds for now.

How to Profit: Investing in the European equity markets as we head into the summer months does not look like a great idea, as the US equity markets continue to act more favorable. Any rebound in the European markets or in ETFs like EWI and EWK should be used to lighten or liquidate existing positions.

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