DAX analysis: After climbing an impressive 18% last year and 20% the year before, the DAX has made a decent start to the new year, up a good 2.2% year-to-date. But it is early days and with valuations looking a little stretched and the economy not doing so well, we could see correction first before the market resumes higher.

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Before looking at the charts, it is important to remember that earnings ultimately drive markets. But at current levels, equities are looking increasingly less competitive compared to bonds…

Valuation concerns could come into focus

Indeed, the DAX is trading at a price-to-earnings (PE) ratio of around 20x which is higher than its 3-year average PE of 15.3x (although still far below the S&P 500’s PE of above 30x). The German materials and technology sector valuations in particular look quite overvalued at 83.5x and 66.1x, respectively.

Across the pond, US markets are looking even more pricy. If Wall Street corrects, the DAX is unlikely to be able to buck the trend.

As per Bloomberg’s analysis, US stocks are nearing their most overvalued levels relative to corporate credit and Treasuries in nearly 20 years, based on the earnings yield. This metric assesses how much profit companies generate relative to their stock prices and compares it to the yield investors earn from bonds. 

Currently, the S&P 500’s earnings yield stands at 3.7%, marking the lowest level compared to Treasuries since 2002. In relation to the 5.6% yield on BBB-rated dollar corporate bonds, stocks are approaching their lowest comparative level since 2008. 

Historically, when equity yields fall below bond yields, as seen since the early 2000s, it often signals challenging times ahead for the stock market. However, so far, we haven’t seen any major signs of weakness on Wall Street. Could that change this year?

DAX technical analysis: Weekly chart

For now, the DAX remains in an impressive long-term uptrend. The Germany index bottomed in October 2022, and it has since only had two serious corrections in the pursuing years, both of which only shaved off 10% before dip buyers stepped in to drive the market to new all-time highs. All other pullbacks haven been quite shallow of around 5-7 percent. As a result, the DAX has remained mostly above the middle part of its bullish channel. Hence, we have only seen only brief dips below the short-term 21-week moving average. Price action has been very impressive indeed.

However, as the index has already tested the resistance trend of both the long-term bullish channel (established since pre-Covid era) and that of the medium term channel (established since Q3 2022), there is a danger now that we could see another correction in the days or week ahead. What’s more, the Relative Strength Index (RSI) is again in a state of negative divergence on the weekly time frame. In other words, it has recently made a lower high at overbought levels of above 70.00, when the underlying DAX index made new all-time highs. This divergence suggests that the strong momentum could be losing steam and that a correction is needed to move the RSI back to neutral-to-oversold levels again.

If history repeats itself and we do see a correction, a 10% drop could send the index back to the support trend of its medium-term channel, where we may see the resumption of the bullish trend again, unless some major bearish catalyst emerges to cause a more severe correction. But our bearish scenario base case is only a 10 or so percent correction – if it happens.

DAX analysis: Technical level to watch on daily chart

Zooming into the daily chart and we can see recent price action more clearly. After topping out in December, the DAX retreated around 4% from its all-time high before bouncing back. It found support right where it needed to: around the October high of 19680 as old resistance turned support.

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Today, the index is testing a prior broken support zone around 20260 to 20330 area (shaded in orange on the chart). If December truly marked the top in this cycle, then this is where the bears would like to step in. So far, we have only seen modestly selling pressure here: the index tested this zone yesterday and fell a good 140 points, before bouncing right back up to have another go today.

The bears will need to break down some key support levels to make a serious dent in this rally. Short-term support now comes in around the 20K mark, which served as resistance in the last two weeks of December. What I am looking for now is a daily close outside of the rising wedge or bullish channel observed on the daily chart.

If that happens, only then will things look and feel interesting. The bears must await a clear reversal signal given how strong markets have been last year, despite all the doom and gloom out there.

Source for all charts used in this article: TradingView.com

— Written by Fawad Razaqzada, Market Analyst

Follow Fawad on Twitter @Trader_F_R