The Dow Jones Industrial Average is gaining 5.15% since the start of the year and DIA, the popular ETF that tracks the average, is gaining 5.27%. After January 16, the average and its ETF have been in a mini-parabolic move that brought them in overbought territory. I also present my (simple) explanation about the cause of this rally.
It may be seen that last time the RSI(14) of DIA exceeded 70 a substantial correction followed. However, that does not imply that necessarily the same will happen this time around but it is good to be aware of past behavior, especially recent, because the same players dominate the market with the same strategies.
Althought shorting DIA when the RSI(14) is greater than 70 is a losing strategy because of the positive bias of the average and backtesting shows that the win rate for 3% profit target and stop-loss has been less than 41%, nevertheless, it has worked 4 out of every 10 times. This is something to keep in mind when the focus is on the next trade only.
My explanation for this January rally that resembles the January rally of last year is that fund managers flock at the beginning of the year because they need to generate a profit to serve as a cushion in the case of a market decline later. Those who have worked in fund management business understand and appreciate the idea of a profit cushion. If the year starts with losses, then that causes a lot of stress and uncertainty to both managers and investors. Thus, with the cushion objective in mind, fund manager flocking occurs at the beginning of the year and the rally has very little to do with fundamentals, values, politics or anything else. These will be examined after the cushion is generated.
Disclosure: no relevant position at the time of this post and no plans to initiate any positions within the next 72 hours..
Charting program: Amibroker (Charts created with AmiBroker – advanced charting and technical analysis software. http://www.amibroker.com/”)