The eagerly watched for retest (of the prior lows) finally came to fruition on Wednesday of last week. Although, the ER2 (Russell 2000) didn’t quite make it down far enough to touch the recent nadir. This was not the case for the S&P and the Dow. These two benchmarks actually exceeded their prior low points before the Bears finally decided that – enough was enough – and began covering or buying back their short positions. In addition, the market sell-off had gone far enough that the Bulls found a perceived "value area" in which they could put new money to work. This chain of events created a massive order imbalance that precipitated the violent reaction that is the rebound. Much like a rubber band that is stretched to its limit, the reverting is swift.
Was this an oversold bounce before the next shoe is to drop? Or is the correction over, thus setting the stage for a challenge of the February highs? These questions are foremost on the minds of both traders as well as investors.
My take on this is that to get a handle on the future direction of the market, we have to turn our focus to the character of the rebound. What do I mean by this? First, is the recovery rally on higher than the normal Volume? So far, the rebound has been on much lower Volume, which in itself maybe troubling for the Bulls. The lower Volume is symptomatic of a lack of conviction on the part of institutions.
Next, technically the market has to work through all the levels of resistance that were left because of the severity of the sell-off. There are plenty of longs that are trapped because they didn’t exercise proper risk management. These folks now find themselves in the unenviable position of "hoping and praying" that the market continues to rally up to their break-even point, so as to make them whole again.
To get a visual let’s look at some charts. We’ll first direct our focus to the hourly chart of The ER2 (below). What is most noteworthy is the almost uncanny adherence of price to the Fibonacci retracements. Notice the almost perfect rally up to correct 50% of the high-low swing move from the past three weeks. We would need to close above the 61.8 % retracement to technically change the intermediate term trend from bearish to bullish.
For a longer term perspective let’s take a glance at a weekly continuation chart of the same ER2.
As was the case with the smaller time frame, take notice of the similar price reaction to the Fibs. You can’t ask for any more perfection than that! This is a great example of the self-fulfilling prophecy at work.
For a trader, Fibonacci retracements can be a useful tool. They can be utilized as a way to measure the strength or weakness of a rally. In a strong rally the pull-backs should be shallow (no more then 38%) before a resumption of the trend. Conversely, the line in the sand is a correction of no more then 61.8%.
The FOMC meets this week, and of course, all eyes will be on the statement realized around 11:15 PST. A small minority of traders believe that the recent mortgage melt-down will be enough impetus for the fed to ease, but most are resigned to the fact that Interest Rates will remain unchanged. Generally, it is not advisable to trade amid this report. The market goes through a sequence of wild gyration immediately following the release of the report and then tends to settle into a direction. This is when you will get a higher probability trade to set-up.
The Bottom line: The Bulls are still not out of the woods yet. The Fed decision this Wednesday may play a role in determining the future direction of the market. In the very short-term the market has rallied right up to some significant resistance (800 on ER2), albeit on light Volume. I’ll be monitoring these price levels very closely and will become more aggressive on the long side, if we can break above the 800 level. But as always, I will let the market decide.