The Dow Jones Industrial Average on Thursday rose another 0.82%, bringing the eight-day stamp to about 6.5%. The sharp rally, which came off a higher low as compared to the August lows, surprised many bears that growled loudly just a few days ago. While this has left the DJIA in near-record overbought territory on both its daily and weekly charts, a further squeeze higher into next week’s options expiration cannot be ruled out.
As a gentle reminder, note that some of the sharpest rallies tend to occur in downtrending markets. Behind the dynamics of these snapper rallies are emotionally driven short sellers that blindly chase stocks into the hole with little to no risk management in place.
So when algorithms and dip buyers come in for bargains, these short sellers have to scurry and quickly buy back their stock with both hands. Potential margin calls only make this worse as it forces short sellers to square their positions which in effect has them falling over each other as they outbid each other to cover stock.
Dow Jones Industrial Average Charts
So far, the sharp rally off last week’s lows has “only” managed to get the Dow Jones Industrial Average back to the broken 2009 uptrend line, which would be a logical spot for some resistance to come in on a weekly closing basis.
Looking at the below chart, however, it must be noted that during the August/September selloff, the October 2014 lows held on a weekly closing basis. Nonetheless, the recent selloff in the DJIA did break it below the 2009 support line for the first time, and that should keep the index capped for a while.
But that doesn’t mean a retest of the summer highs north of 18,000 can’t be reached in a good fourth-quarter rally.
From a momentum perceptive, the eight-day rally (so far) has left the popular McClellan Oscillator in overbought territory for the first time since summer 2012. While not an immediate-term signal that the DJIA must turn back lower, it does indicate that at the very least the rate of change from here on forward will likely slow down and eventually lead to a turn lower for consolidation purposes.
This context is crucial to understand, particularly as it ties in well with short sellers getting squeezed.
Another way of looking at the entire price action since late August is to see it as a big bear flag pattern that is so far still taking place below broken support and below its 100- and 200-day moving averages, which in turn are now sloping to the downside.
While aggressive traders could try and play the DJI index from the short side with quick stabs, the more cautious active investor will want to see and measure the next consolidation push lower.
The more violent the next bearish reversal is the more likely we ultimately see a break below the 16,000 area.
A moderate mean-reversion move back into the 16,500-16,600 area should be bought for further strength in the fourth quarter. In other words, active investors should not chase the index up or down, but rather look to sell/fade rallies and buy dips for bounces.
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Successful trading and investing starts with a plan. Download Serge’s essential trading plan, The Essence of Swing Trading e-book. As of this writing, he did not hold a position in any of the aforementioned securities.