This morning the markets tagged a new high, which is not unexpected as market makers like pushing the market into areas a lot of automatic trading will be triggered from breakout buyers and stop-losses from short bears. This is how market makers pay their alimony and kids private school tuition. But the big question remains, with the market more richly valued than it has been in three months, are value investors still going to line up and buy at these higher levels? Or will the buying taper off once all the autopilot buying has run its course?
This is a critical juncture for the markets as it will chose between a directional move higher or returning back into the trading range. Traders need to decide if they want to buy this breakout or sell it. Over the past three-months, buying the dips and selling the rips was the only reliable trade that made money. Will this swing-trading pattern continue here, or is the market ready to move into a new phase?
In individual stocks WON likes to see a convincing breakout on higher volume that demonstrates large institutional support. The same type of price and volume action in the indexes today would be reassuring for a buyer of this breakout. A feeble breakout will show a lack of conviction and could indicate this rally is in the last stages before breaking down.
Double bottoms and double tops are common reversal patterns. A key to the double top/bottom is the second move must exceed the first. In our case, the second peak must exceed the previous peak. The reason this pattern works is a large portion of investors trade technical levels of support and resistance. Previous highs and lows make popular areas where traders will cluster buy and sell orders. They assume crossing these previous highs and lows will clearly indicate a breakout or breakdown. The double bottom and double top patterns work because the second leg triggers a flurry of automatic buying or selling that quickly fades away before the market reverses.
If you ever want to know what the market will do next, the most reliable indicator is identifying what move will make the greatest number of people look stupid. There is a lot of complex psychology and pricing theory behind this phenomena, but figuring out what direction the market is headed is no more difficult than determining what direction will hurt the greatest number of people the most.
If we were to apply this theory here, we’ll see the last week and a half knocked the crap out of bears as the market bounced hard after the previous slide. By making a new high, the market has forced almost all of the bears out with their tail between their legs. If most bears are bloody and on the sidelines, it is hard to hurt them any more, so who will be the market’s next victim? There are a lot of bulls that just bought this week’s rally and today’s breakout. But this is not a binary game of just bulls and bears. There is a third important contingent that needs to be included, those sitting on the sidelines. The market can humiliate people not in the market by running up sharply and leaving them behind. This is exactly what happened in the first quarter of this year. Everyone was on the sideline waiting for the inevitable pullback, and the market humbled all those traders by rallying non-stop and leaving them in the dust. The pain felt by those left out of the market during the Q1 rally got so great, they ended up chasing the market higher. The only problem is most of the chasers bought in near the top before the market rolled over in April, adding insult to injury.
Bears are knocked out of the market right now and no longer a factor, so we need to evaluate who is more venerable currently, bulls or those sitting on the sidelines. But time frame is critical in this. Over the short-term bulls are probably most venerable, but over the longer-term all the investors hiding out in bonds are at risk. But the bond story took years to build up and thus will take years to unwind, so that long-term bond story is not much of factor when figuring out where we are going next week. For this equity rally to continue higher, we need a large number of traders reluctant to buy the breakout. The more reluctance, the greater the chances are for the rally. But on the other hand, if people are excited by the rally, then lookout below.
Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.