Why Dow 20k matters
Posted by Danny on January 10, 2017
Stocks have been trading rather flat in recent weeks, and several attempts for the Dow to get above the 20k milestone have come up short. More on that later in this article. First, let’s have a look at the current situation in the S&P 500:
A few weeks ago we observed how stocks needed to catch some breath, giving indicators the time to revert from rather overbought levels. We now see that the faster Earl (blue line) has bottomed out and turned up already and the MoM is back to neutral levels. The slower Earl2 (orange line) is still headed lower and nowhere near a bottom.
The bearish divergence remains in place and an index making new all time highs with Earl below the zero line is a tricky setup. The overhead resistance levels are still putting a ceiling above this market and it appears as if momentum is not strong enough to push much higher at this moment.
When and how the Dow gets above the 20k mark is widely watched and is determining the near term price action right now. Much like an athlete would do if he has failed to clear a hurdle, this market may need to take a few steps back before it can try to get over on the next attempt.
Some observers contend that Dow 20k is not really relevant. That may be true from a long term investor’s point of view, but most of the daily market volume is coming from short and medium term traders, not from long term investors. And for them it matters. Why?
It is human nature to try to simplify things when faced with something as complex as a stock market. That’s why investors tend to use round numbers as reference points and mental stop or target prices. An investor who has bought a stock at $67 and sees it climb to $76 may tell his wife that he is going to take some profits when it hits $80. That’s easier to remember than $81.27. This simplification in traders’ minds creates a “round number effect”. Options being priced at round numbers contributes to that effect as well. There is also the known psychological phenomenon that makes a $19.99 product look cheaper than a similar item priced at $20.00. This “left digit” effect in combination with “round numbers” effect makes for psychological barriers in widely watched stock indexes like the Dow Jones. Some common patterns can be observed when an index heads into a major round number. We can see the most typical price action in this S&P 500 chart from 2014, when the index climbed above 2k for the first time.
The first variation is: coming up just short and falling back. That’s what we saw in July 2014. The reason for this is simple. There are always some traders who have decided to sell some if market hits 2000 and they put their sell orders just below that mark. Other short term traders who anticipate that behavior add some sell orders just below 2000 as well, just hoping to benefit from an expected pullback. This supply coming in just below the round number causes the pullback.
The second variation is: crossing above, but not able to hold up there (= fear of height sets in). That’s what we saw in Aug-Sep 2014. The hurdle was cleared but the market never got properly away from the 2000 level. This is left digit effect. Traders’ minds need some time to get used to see “2” in front. Failing to get away from 2000 was followed by another pullback.
In Nov 2014 the market got back above 2000 again and then it got away from it. Subsequent pullbacks retested the 2000 level, which acted as strong support, very typical price action after a breakout.
Of course, things do not always evolve in this exact fashion. If a market has a lot of “juice” left when coming into a round number barrier then it will often cut straight through without looking back. There are sell orders just below the round number, but they are easily absorbed and the market moves on.
If on the other hand the market is rather tired and momentum is fairly weak, then the predictable sell orders sitting just below the round number will stop the advance. And when that becomes clear more investors may decide to sell. It becomes a self-fulfilling prophecy at that point.
And with each new failed attempt at a psychological barrier it becomes more visible for investors. It can go on for years and become a market obsession. That’s how the Dow ended up taking more than 15 years to get above and away from the 1000 level in 1965-82. That’s how the FTSE 100 has been spending the last 16 years trying to get above and away from 7k.
Will it take that long to get above and away from Dow 20k? We don’t know. But if the Dow happens to struggle for weeks at that level, then weeks become months and eventually months can become years. A big round number is not a strong psychological barrier on the first attempt to clear it. But it comes a stronger and more visible barrier with each new failed attempt. If and how the Dow gets above 20k will probably tell us how much “fuel” is left in this market and that is an important takeaway.