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Divergence and a Trade Idea in Italian Stocks

08/17/2017 2:50 am EST


Landon Whaley

Editor, Gravitational Edge

Trade idea: short the Italian equity market via the iShares MSCI Italy Capped ETF, EWI. As long as EWI trades below $33.50, then you can use rallies above $30.30 to initiate new short trades, suggests Landon Whaley of Focus Market Trader.

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The best trading opportunities come when investors’ perception of an event, or market, diverges from the most probable outcome of that event or the most probable direction of that market.

The most attractive opportunities present themselves when there is a shift in the Fundamental Gravity of a market from one bias, bullish or bearish, to the opposite but investors are slow to react. These divergences get me salivating like Pavlov’s dogs. Right now, there is a divergence occurring in the Eurozone that is being ignored and providing a compelling short opportunity.

The Big Fundamental

This divergence is occurring because Germany’s Fundamental Gravity is shifting from one that provides a boost for equities to one that will prove to be a headwind in the months ahead.

In economic terms, Germany is the workhorse for the Eurozone economy like Barry Sanders carrying the ball 40 times against the Cowboys in ‘94. If you want to know the most likely trajectory for Eurozone growth, look no further.

Yet, every major German economic indicator, save industrial production, has been slowing for the last three months.

No part of the economy has been spared as both the manufacturing and service activity are waning. Everywhere one looks, there is slowing data: steel production, car production, factory orders, retail sales and labor productivity. The number of building permits, which are a valuable growth indicator, have fallen off a cliff since last year.

Finally, and most importantly, excess liquidity in the economy has been declining for well over a year and that downtrend regained momentum in January.

The reason this shift in Fundamental Gravity is a big deal is because an economic environment characterized by slowing growth, and less excess liquidity, is not friendly for equities.

The DAX, which is the German equivalent of the S&P 500 index, peaked at a brand new all-time high six weeks ago on June 20 and has since declined 5.3%. Despite slowing economic data and a rollover in the DAX, we are seeing two interesting divergences across other Eurozone equity markets. 

The Italian job

Given that Germany is the Eurozone locomotive, it makes sense that France, Spain and Italy would follow its lead. Although, French and Spanish equities are currently declining alongside German stocks, Italian equities apparently haven’t received the memo.

The Milan S&P/MIB index, which represents Italy’s equity market, peaked at a two-year high on August 8, and has since declined just 1.6%.

The Milan index is moving lockstep with its U.S. exchange-traded fund equivalent, the iShares MSCI Italy Capped ETF (EWI).

EWI peaked at a three-year high on August 8 and is now trading 1.4% below that high.

Riddle me this: how have Italian equities been able to buck the trend in Eurozone equities by continuing to grind higher months after equity markets peaked in France, Spain and Germany?

Since peaking those three equity markets have lost over 5% each, while Italian equities have managed to gain another 2.6%!

Opportunity anyone?

There is no way Italian equities remain elevated at three-year highs while every equity market around them is in a Fundamental Gravity-induced pullback.

With Germany economic data slowing, pulling German equities down with it, there is a high probability that Italian equities follow suit.


The Short Trade idea

You can short the Italian equity market via the iShares MSCI Italy Capped ETF, EWI.

As long as EWI trades below $33.50, then you can use rallies above $30.30 to initiate new short trades.

Depending on where you enter the trade and how much room to move you want to give this trade, you can use a risk price between $30.73 and $33.50.

Your risk price line in the sand is $33.50, if EWI closes above that price, then you should exit any open trades.

If the trade moves in your favor, I would book profits on any decline to the $27.56 to $26.34 range.

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