Traders have been conditioned to the fact that the trend is their friend. When a trend is clearly moving in your favor, attention is paid to little else. Trade with that trend and the results will take care of themselves.
Knowing this to be true, I spend a great deal of time trying to determine where the broad market will go. Coming off a sharp V-shaped rally from the March low this activity has become more difficult.
A chart of the Dow Jones Industrial Average (Dow) illustrates the problem. The cascade lower during February (red line) was quickly followed by a similarly sharp rally (black line). This created a classic V-shaped recovery. Since then, prices have moved in a tight trading range (black dotted lines). I have long felt that the declining 200-day moving average (MA) on the top would act as a ceiling to stop any rally and the rising 50-day MA would serve as a floor that stopped any decline. As the Dow has been unable to determine which direction to take since early May, the spread between the moving averages has narrowed. At the start of May, there was nearly 1,400 points between the averages. Today the two are separated by a mere 224 points.
I have long compared the compressing range to a coil. When we step on a coil and apply pressure, we know it will eventually snap back. As soon as our foot is moved, the spring shoots higher. The market will act in a similar manner. As prices stay in a range, the coil is further compressed. When the pressure is removed, prices will move dramatically. I expect the movement to be swift and material. A rally above the 200-day moving average would take the Dow over 9,000 (black box) while a move lower that violates the 50-day MA would take the Dow toward 7,600 (red box). For now, watch this range to gain a clue about the market’s next big move.