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Dow Crosses 20k; But What's In a Psychological Price Point?

Dow Crosses 20k; But What's In a Psychological Price Point?

2017-01-26 14:14:00
James Stanley, Strategist
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Talking Points:

- The Dow Jones Industrial Average crossed 20,000 for the first time ever yesterday.

- This creates pandemonium around the market that will produce divergent opinions; many new traders get excited while seasoned traders will often cynically ignore such events as unimportant. Below, we investigate.

- If you’re looking for trading ideas, check out our Trading Guides. And if you’re looking for ideas that are more short-term in nature, please check out our Speculative Sentiment Index Indicator (SSI).

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It finally happened. Yesterday marked the first time that the Dow Jones Industrial Average climbed above the 20,000 level after weeks of close calls. And you’ve probably already heard about this – it’s been widely broadcast throughout media as if it’s an event unto itself. But seasoned traders and those with statistical backgrounds will often remark that there is little to no significance of such an event - as the level of 20,000 is merely a ‘round’ number between 19,999 and 20,001, carrying no greater importance because of its rounded, even nature.

But anyone that’s ever went shopping at a store would probably see the logic of disagreeing with that vantage point, as retailers heavily use the strategy of ‘psychological price points’ in order to make products seem cheaper in order to get customers to more actively buy. When you see product that costs $13.99 or £44.99, this is an passive strategy from that business to try to make that product seem just a bit cheaper, and not only does it make logical sense but, it works; that’s why retailers keep using it and that’s why you’re probably going to be purchasing products that end in ‘.99’ for the rest of your life.

This can also be applicable to markets. After all, what are markets but manifestations of human psychology and sociology based on the context of facts at the time? This is why things like PE ratios can fluctuate because investors, as a group, will exhibit trends and phases in a collective fashion that can show up as trends on a price chart. Anyone that’s traded Forex is probably well-aware of the Euro’s historical struggle with the ‘parity’ figure, not to mention the applicability of ‘psychological whole numbers’ in intra-day strategies. And without a doubt, ‘psychological price points’ can impact group market behaviors as well, and watching how the Dow Jones traded with the psychological level at 10,000 can illustrate this.

After first touching the 10,000 level in March of 1999, the Dow finally climbed above on April the 5th. Optimism was as strong as any time in recent history; this is when Schiller PE ratios were on their way to driving up to all-time-highs (investors were loving stocks as much as any time in history), and hope was continuing to drive otherworldly valuations into companies that never really made any money. This is the ‘dot com’ boom when practically any web-based company could elicit excitement based on the prospect of modernizing a business plan to integrate the power of the internet. We could ‘technically’ call this a mania given how aggressively stock prices had moved up relative to earnings.

And for a few months, the Dow Jones stayed above 10,000 with even a little bit of extra drive-higher after a support check in October of 1999. But in January of the year 2000, selling started in the Dow and prices ran below that 10,000 level, albeit briefly, to serve as somewhat of a warning sign that all was not well. But by then, it was already too late; the all-time high had been set and that hopeful optimism that had driven prices well above 10,000 had already started to wane. The ‘psychological price point’ of 10,000 on the Dow Jones Industrial Average had served to make stock prices seem more expensive, in the same way that a price at the store might seem more expensive because of a simple penny or pence of difference.

This isn’t a directly bearish driver unto itself; this merely tempers optimism and strength. But it can leave a market in a vulnerable state so that as soon as a bearish driver shows up, after which a significant sell-off ensues. This is what happened in September of 2001, leading to a crash of more than 30% in stock prices in the following two years.

Dow Crosses 20k; But What's In a Psychological Price Point?

Chart prepared by James Stanley

The Dow Jones Industrial Average finally climbed back-above 10,000 in April of 2005, but the index wasn’t done with that level yet. In 2007 the Dow Jones was working its way up to 14,000 when the housing collapse began to envelop markets. Two years later, the Dow Jones was at less than half of that level when trading below 7,000. But as TARP and then three rounds of QE and Operation Twist catapulted American markets higher, bullish price action was restored and each of these psychological price points offered some element of support or resistance on the way up; that is until recently.

Dow Crosses 20k; But What's In a Psychological Price Point?

Chart prepared by James Stanley

Conclusion: Should I Buy, Sell or Walk Away?

None of the above based on the simple fact that Dow Jones is above 20,000; as this is just a psychological price point and, in and of itself not really worth a whole lot. But this is another factor in the ‘stocks are expensive’ camp that could temper optimism moving-forward. Right now, optimism is in full-blast and equity markets around the world are rallying. So you don’t want to look at a single contrarian factor to claim that the majority of the world is ‘wrong.’

But the context here is relevant: The Fed wants to ‘normalize’ policy and the deeper this stock rally runs, the higher the probability that we’re going to be seeing higher rates before long. Stocks are expensive on a historical basis; can they get more expensive, sure, but from historical observations, the odds of continuation aren’t great when stocks are valued this handsomely. And the source of this hope seems to be very political in nature – which can always be dangerous.

Collectively this makes for an imposing backdrop. But despite this, investor are continuing to bid prices higher. For the astute investor, 20k has just become a support level for short-term strategies and, if/when we break below, this is a level of resistance to use as prices break down. Like any other time, traders should adhere to price action to determine strategy application; don’t let the excitement or hope from others infect your trading strategy because at the end of the day, your strategy needs to be based on trying to work-around the psychology of the market rather than falling prey to it.

--- Written by James Stanley, Strategist for DailyFX.com

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