Hindsight is beautiful. Many investors look backward and imagine what could have been. If only we had bought Google (GOOG) at the IPO. If only we had shorted oil near $150. Using such a bias allows us to simplify complex markets and reassure ourselves that the next time such an opportunity arises we will act differently.
Currently we find ourselves at such a moment. When the Dow Jones Industrial Average (Dow) skidded to a low of 6,547 on March 6, many feared the worst. Since then, prices have rallied 29% in a relentless fashion, rising during eight of the last nine weeks. With prices moving in one direction, many investors are left grasping for an opportunity to buy stocks. Since they missed the initial rally and now view the market as severely overbought, they have no desire to buy. If only the market would pull back, these investors believe, they could buy stocks and continue the ride higher.
Those wishing for such an opportunity may soon get one. The Dow is 3% lower on the week and shows troubling signs. In bullish environments market leaders often charge higher as prices start each day flat and strengthen over time. Further, in bullish markets all news is interpreted positively, leading prices higher. but this week has been different. Each day stocks have opened higher and then consistently dropped. News which would have been ignored weeks ago is now seen as an opportunity to drive prices lower.
As the psychology of the rally changes, we must watch for indications that prices are set to reverse. When you consider how far this rally has come in a short time period, profit-taking should be expected. The important factor is not where prices are one or two weeks from now, but the underlying tone of the market two or three months hence. Investors who missed the initial rally will receive the pullback they are waiting for. The question is whether they will use the low prices as a means to enter this market, or, scared by the prospect of even lower prices, remain on the sidelines.
The key to riding out this unstable market is to identify a price where a pullback should stabilize. I focus upon the 50-day moving average (MA). If this bull movement remains in effect, we can expect the Dow to trade toward the 50-day MA before bouncing higher. Currently that gives us a downside target of 7,785. Over the coming weeks, keep your eyes on this number. If we can pause there and then move higher it lends credence to the view that the March lows will hold. Then those who missed the rally will have to decide how to react to a 10% pullback: take advantage of a second chance to buy this rally, or hold onto their money in fear that the worst is not yet over.