What do they say?

Commentary: It has been a hectic couple of weeks and recent movements have continued to leave traders wondering which direction the markets will be headed next. As you can see from the charts below, the large-cap indexes that represent the S&P 500 and the Dow Jones Industrial Average have fallen below the support of their respective 200-day moving averages. On the other hand, the smaller cap indexes that are represented by the Russell 2000 and the Nasdaq have manged to hold above the support levels and look like they could be positioned to make a move higher.

IN PICTURES: 7 Tools Of The Trade

In our previous reports, 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 Friday’s selling pressure has left a lot of shares in weak hands, and these shareholders 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 that Friday’s bounce off the 200-day moving average suggests that this level of resistance might be stronger than many bulls would like to believe. If SPY is able to break above its 200 DMA then traders will quickly look to the $114-$115 levels as areas for the next wave of possible sellers. This was the early January high and an area of trading activity a few days ago.

Source: MetaStock

The Diamonds Trust Series 1 (NYSE:DIA) ETF, which tracks the Dow Jones Industrial Average, reacted almost in an idential fashion as SPY for another week with a strong reaction after testing its nearby 200-day moving average. While the majority of the week was spent trying to battle back from last week’s losses, the DIA gave back some of its gains 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.

Source: MetaStock

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 200-day moving average. This is an important clue as it shows some leadership coming from the tech sector. Despite the fact that the QQQQ chart remains under pressure from the bears, 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.

Source: MetaStock

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 much stronger recently as it bounced nicely off its 200-day moving average. 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. As a market leader, IWM should be monitored closely to see if it begins to falter ahead of its peers.

Source: MetaStock

Bottom Line
Investors were certainly on edge this week as traders tried to fight back after last week’s losses. 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 based on Friday’s market action. Many stocks are well under support levels and are not looking healthy. Most stocks are oversold and could continue to 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.

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!