There was a sharp drop in US stock markets on Friday after some early strength. We expected something like this to happen as we said in the earlier of the two April 1st editions when warning that rallies in US equities would stall. A reminder of why:
Compressions show moments of great uncertainty, marking general disagreement between market people about the next price direction. They are the opposite of extensions which occur when there is consensus. Trends often start with compressions, even though we cannot usually tell which way that trend will be – this leaves us with two choices, the first of which is to ‘go with the break’.
When doing that, we wait for the compressed condition to resolve itself and then chase the market in whichever direction it ‘breaks’.
We sometimes warn that patience is needed when an apparent break is occurring as it must be confirmed by the market closing outside the compression. This can be frustrating as the price may continue to move in the direction of the break for some time before it is possible to take a trade with confidence. In the long run this is better than jumping in on early evidence of a break, as prices can easily stall and move back into the compressed area, leaving the trader with an ‘orphan’ position either long above or short below market levels. ‘Going with the break’ is the first choice.
The second is to wait for a ‘return movement’ to the compression sometime after the break has occurred. There seem to be two current cases of this at the moment, in the Nasdaq and in Brent crude:
Here the market compresses and breaks (downward in both of these, but it could be upward) and after a few days rises back to the compressed level where the rally stalls and weakness resumes.
This is often a better opportunity to adopt a trade as the price direction is already apparent from the original break and the risk can be held at a lower level because the price should not penetrate the compressed area, although it may push into it a bit, as did both of these examples.
The reason for this frequent feature of compressions is the ‘strange attractor’ effect that shows up in many complex systems. Markets are just one kind but many others exist in weather and ocean systems, geophysics and epidemiology - in fact anywhere that feedback links cause with effect. We watch for this from our lookout post here but it is very useful from a trading standpoint if you watch for it too.
There will shortly be a revised version of our userguide available on our website that will emphasise this important aspect of compressions.