Stock market back to range trading

Sure, NASDAQ broke above the magical psychological level of 2,000 and the S&P 500 above the magical psychological level of 2,000 a few days ago, but as I noted on Monday all of that is merely psychological and not fundamental. I also noted that:

Left to their own devices and desires, traders love range trading. Up, down, up, down... Traders love anything that moves. Movement means transactions, transactions mean fees, fees mean big paychecks and big bonuses. Traders would be happy if the market continued moving up strongly, but if buying volume peters out, traders will reverse on a dime and bet on a reversal and a decline back towards the lower end of the trading range. And then start all over again.

Sure enough, that is exactly what we have seen this week. With little remaining buying volume after breaking above those psychological levels, traders and short-term speculators reversed and bet on the downside.

We have also seen another trader and short-term speculator favorite: selling into strength. The market opens strong and then tanks. It does that because Traders manage to psyche each other into covering short positions at the open and meanwhile other traders and speculators are opening new short positions at those higher price levels. It is a game of chicken, but can be quite profitable.

From here, traders and short-term speculators could continue their negative bias. Especially as some hedge fund managers talk up their pet story about the spring rally being a "bear market rally" and that "another leg down" is coming. That incites a lot of naive traders and short-term speculators to bet on a steeper decline.

But... if no such steep decline materializes soon enough, they begin to lose patience.

At some point, after a big enough point decline and enough loss of patience, the lower end of the trading range is encountered. Unless there is heavy selling volume, traders and short-term speculators will begin to reverse and start betting on the upside. Meanwhile many of those naive speculators who believed that a new down-leg was imminent get burned and a dramatic short-squeeze occurs. This accelerates a new bull up-leg towards the high end of the trading range.

Once again, none of this is about economic or business fundamentals. News headlines can moderate or accelerate the bias of the process for the day, but the underlying process is about range trading.

Eventually, there is either enough mutual fund buying at the upper end of the range or mutual fund selling at the lower end of the range for the market to break out (up) or break (down.) But, right now, we are experiencing range trading with no clear net bias by mutual fund managers.

The monthly employment report for July that comes out Friday morning could incite either a break further towards the lower end of the trading range or supply the catalyst for marking the lower end of the trading range, or could be a non-event. The actual economic fundamentals will not matter so much as how traders and short-term speculators have themselves pre-positioned and whether the "smart" money piles on for a further decline or buys to kick off a short-squeeze.

A sharp move, up or down, occurs when the "smart" money detects that the bulk of traders and speculators are "leaning too far in the same direction." Give the rug a swift tug and they all go scrambling to close and reverse their positions, further accelerating the change of trend, relative to the direction "the herd" was leaning.

-- Jack Krupansky