Is It Over? And What To Expect Next

I ended last week's pre-holiday missive with the following:

"It is easy to say the bulls are due. Really due". 

And as if right on cue, stocks proceeded to bounce hard the following session with the Dow Jones Industrial Average enjoying its biggest one-day point gain in history: 1,086.25. Nice.

To be sure, the bounce was to be expected. The market was oversold - as in VERY oversold on - just about every metric. The sentiment was reaching "give up" levels. Technical support zones had been obliterated. Trend measures pointed straight down. Market models flashed sell signals across the board. Everybody was now a bear. And the VIX had finally exceeded the magical 30-mark. As such, once the White House assured everyone that Jay Powell's job was "safe," (and for the record, the Fed Chair can only be fired for "cause" - aka malfeasance) an explosive, sigh-of-relief / short-covering / it's-time-to-go-the-other-way rally began. It will suffice to say that Wednesday was a good day.

But then came the reversal early Thursday morning. In keeping with the current trend, traders wasted little time returning to the sell button. If you will recall, prior to the big bounce, the game had been to sell into EVERY advance the indices offered - no matter how short or small. So, with the market sinking again, the goodness of Wednesday's algo-induced blast appeared to be at risk.

Well, until 2:30 pm eastern time, that is. At that point, the boys trained their computer toys on the buy side. Word was that some $60 billion in pension money needed to be invested. So, in the ensuing 90 minutes, the Dow surged 860 points. Yowza! Talk about a perfect example of computers chasing their tails.

It was at this point that the, "Is it over?" calls began. Two straight up days. A key reversal. Losses quickly being erased. Suddenly everybody was feeling better about the market. Suddenly it was time to "take advantage" and to "buy the dip," right? Or so I was asked.

My response to the inquiry of whether or not this was time to abandon our risk-managed positions and reinvest the cash on the sidelines was simple, "Not so fast!"

The Crash Playbook Back In Play

I explained that the current decline represents a classic "waterfall decline" or something William O'Neil termed a "bad news panic." I opined that since the environment was now identifiable, every trader on the planet was about to implement what I call the "Crash Playbook".

I have reviewed the playbook many times over the years and my guess is that most readers have their own versions by now. So, let's turn to chapter 3, "The Dead Cat Bounce."

The playbook reminds us that after an initial painful decline and the emotional low, a bounce of the dead cat variety begins. The surge higher is usually short, sharp, and takes your breath away. I think we can make a check mark here.

The only question at this stage of the game is how high will the bounce go? The level getting the most attention on the topic is around 2600 on the S&P 500 and 24,400 on the DJIA. And should the S&P manage to get through the 2627 level and hold on, technicians can argue that the low of this bear phase had been seen.

What Comes Next?

Let's return to the playbook. History teaches us that after some exciting upside action during these short/sharp bounces, the reason the decline began in the first place tends to resurface. The indices bump into resistance as the initial dip-buyers are back to even, fear returns, and all the traders and their machines go the other way. Thus, the "retest" phase begins.

After all the V-Bottoms that have occurred over the past seven years or so, the question I was asked late last week was, "Dave, should we really expect stocks to go back down? Do we really need a retest?" The answer, in a word, is, yes.

Exhibit A in my argument comes from the good folks at Ned Davis Research. NDR looked back at history and suggests that the markets that most closely resemble the current action were the bears of 1962, 2002, and 2015.

These markets were chosen for many reasons. One of the important criteria was the violent price action into and then out of a bottom. Mathematically speaking, NDR looked for markets where there were four straight one-standard deviation down days followed by a four-standard deviation up day. In other words, they were looking for what we have seen recently - a prolonged flush to the downside followed by an explosion to the upside.

Below is a chart comparing the current market with the bears of 2015, 2002, and 1962.

Historical Review: Expect A Retest 

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Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: none - Note that positions may change at any time.

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