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Finance textbooks paint a picture of markets dominated by rational investors who mechanically minimize risks while maximizing returns. Those of us who trade each day know better. Although we monitor our risk and seek to maximize gains, individuals' emotions play a more prominent role than standard financial theory portrays.

When assessing people's emotions, so much depends not only on what is currently occurring, but also on what has happened in the recent past. Just as someone lightly jostled from a deep sleep will lose their bearings and believe a major event occurred, investors facing a sharp change in circumstances will think the market's backdrop dramatically shifted.

Consider the past two trading days. As the Dow Jones Industrial Average (Dow) has dropped 285 points over the past two sessions, pessimism emanates. While the drop has been broth brutal and broad, it is to be expected. From the market low on February 8 to the April 26 peak, the Dow finished higher 76% of the time. Using a shorter time frame, the Dow closed higher 12 of 13 trading days between April 8 and April 26. Such directional strength was unsustainable, yet few factor this into their reaction to the first back-to-back daily declines in nearly a month.

Viewing the past two days from this perspective, recent weakness seems more rationale. Perhaps we are witnessing a pullback within a continual bull market or perhaps this is a top in the bear market rally. Determining which situation we are seeing is the difference between great gains and large losses. To assist in making the determination, I am focused on the following areas:

  • Volatility Index - After a long period of lower volatility, VIX is spiking higher. However, it has not bettered the peak of 27.50 reached near the February low. Until VIX moves above 27.50, consider weakness contained and the bull market intact.
  • International Markets - From a synchronized recovery high on April 15, international markets have badly lagged U.S. markets. France, Russia, and China have already suffered 10% corrections from their recent peaks and other indices are approaching the 10% threshold. This has created a large performance gap between U.S. and international markets that can be closed by either U.S. markets falling or international markets rallying. An international rally would indicate the current weakness has run its course while escalating losses in U.S. markets would indicate more pain to come.
  • Investor Sentiment - Excluding the constantly evolving issues with Greece, most of the recent news has been positive. Economic numbers show growth and companies are reporting strong earnings. Despite these developments, investors remain skittish. Until we see prices rallying on positive information, and preferably rally on negative information, I will view investor sentiment bearishly.

The bulls have been battered over the past two days. With the Dow below its 10-day, and quickly approaching its 50-day, moving average (MA) weakness is evident. However, daily weakness does not determine long-term trends.

The Dow could pull back to 10,300 and be above both its 200-day MA and 50% retracement level. Pondering an additional 500 point drop may be hard for many to stomach, but is also a realistic possibility. Those who chased this rally thinking prices could only move higher are being taught a costly lesson. However, investors, like us, who remained disciplined and kept their powder dry, are being given the opportunity we have long awaited.

Source: Is the Rally Over?