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Commentary: It only took two weeks for the markets to revisit the lows set on the “flash” crash of May 6. After the quick bounce last week into prior support levels, the markets entered a free fall this week culminating in a gap down near the crash levels on Friday morning. However, the markets rebounded sharply from the gap lower to not only negate it, but finish well in the green. The average gain of the major indexes was over 1% and both trips to these lows have been met with aggressive buying.
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We’ve been hypothesizing that the markets would remain in a trading range because of the emotional reactions at both the April peak and the May lows. With the strong bounce off this week’s low, it appears bulls have been granted at least a short-term reprieve. Traders need to remain cautious however, as the past few days of selling have left a lot of shares in weak hands, which will be anxious to sell on any strength.
In looking at the S&P 500, as represented by the S&P 500 SPDRS (NYSE:SPY) ETF, you can see how sharp the recent decline has been, with several large red candles forming with high volume. The key question for traders will be whether Friday’s bounce will lead to another rally attempt. SPY quickly became oversold and is quite extended from its 20- and 50-day moving averages. If SPY does attempt to move higher from here, the $114-$115 level will be an area to watch for possible sellers. This was the early January high and an area of trading activity a few days ago.
The Diamonds Trust, Series 1 (NYSE:DIA) ETF, which tracks the Dow Jones Industrial Average, reacted similarly to SPY with a strong reaction after testing the May 6 “crash” lows. While the majority of the week was spent falling lower, DIA gave some hope to long investors with the positive close on Friday. There appears to be strong support near $98-$99 and this is a key level moving forward. A drop below that would surely have traders in a panic. Looking higher, the $107 area appears to be a possible area of overhead supply.
The Nasdaq, as represented by the Powershares QQQ ETF (Nasdaq:QQQQ), fared a little better than SPY and DIA in that it managed to hold above its May 6 lows. This is an important clue as it shows some leadership coming from the tech sector. QQQQ managed to close above its 200-day moving average and while the chart remains bearish, the relative strength as compared to its peers is promising. There is still some room underneath before QQQQ tests its lows and if the markets continue to falter, it’s possible that those lows will still come into play as a possible bottom.
The Russell 2000, as represented by the iShares Russell 2000 Index (NYSE:IWM) ETF, is showing a very interesting story. When comparing the price action of IWM versus its larger cap peers, IWM was weaker recently in that it actually traded below its May 6 “crash” lows on Friday morning. However, when looking at the larger trend, IWM remains in much better shape than its peers. Notice how the other indexes are close to their February lows, while IWM remains well above these levels. This suggests that the longer term strength in IWM is still intact, and that the Russell is still in a leadership role. IWM also held above its 200-day moving average on the first attempt of a test. As a market leader, IWM should be monitored closely to see if it begins to falter ahead of its peers.
Investors were certainly on edge this week as the markets continued to probe lower levels until reaching the crash lows. While the reaction was positive for bulls, traders need to remain extremely cautious. While it’s tempting to rush in and start picking up bargains, relatively speaking, stocks were still showing weak performance this week. Many stocks are well under support levels and not looking healthy. Most stocks are oversold and could have a sharp bounce, but there will be many traders looking to cash in on stocks they have held through the recent weakness. This is what makes this environment dangerous, as traders will be tempted with sharp rally attempts only to be met with other traders who have been anxious to get out at better prices. The markets will need to consolidate much further before a healthy trend can emerge. Until then, traders should either trade on shorter time frames, or simply stand aside and wait for better opportunities.
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