Don't Trust a Bounce

 | Mar 07, 2012 | 9:02 AM EST
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"Danger breeds best on too much confidence." --Pierre Corneille

The market suffered its worst selling of the year Tuesday. The question now is whether that was a short-lived stumble or the start of something dire.

The bulls have been very confident all year and the market has been unusual lopsided since the recent rally began in mid-December. The lack of any real worry or concern has produced a large supply of anticipatory bears who have been anxious for a pullback for weeks. The fact that so many were convinced we couldn't keep running straight up probably helped keep the move going, but the dip-buyers and machines relented and we had the first real selling of the year.

Many are quick to declare that a top is in and a correction are under way, but since the low in March 2009, the nature of the market has been to shake off this action and quickly regain momentum. There have been a few times, like last spring, when this sort of selling did mark a major top.

Typically, selling like we saw yesterday leads to a relatively quick oversold bounce. The first big dip is usually bought as folks are quick to dismiss the bearish argument and bargain hunters step up. This market has probably produced a very big supply of underinvested bulls since it has offered so few entry points on weakness for so long. They will be looking to inch in and will likely gain confidence as we hold above yesterday's lows.

Obviously, what we have to watch for are failed bounces. Downtrends develop as bounces fail and the recent lows are taken out. Every time we breach a recent low, stops will be triggered and bears will gain confidence.

The market has not had any failed bounces yet this year, so the confidence of the dip-buyers should still be high. They may have stood aside yesterday, but they will quickly regain confidence once they see a little green on their screens again. The key is that they don't turn into flippers. If the dip-buyers don't have the confidence to stick with a bounce and it fizzles fast, the downtrend can gain steam.

We have some positive early action, and the important thing will be to see how the market acts after an initial gap up. Do trapped bulls try to escape into strength or do the dip-buyers regain confidence and provide support?

I'll be looking for short-term bounces, but if we don't hold above yesterday's lows I'll hit the eject button fast. This is the sort of environment where we often see these confounding V-shaped recoveries, and I'll be watching for that to develop, but the odds of a failed bounce and a failure of yesterday's support are quite high. I'm definitely not inclined to signal the all-clear.

Don't be too trusting of a bounce. The dip-buyers may quickly turn into flippers, and if we retest yesterday's lows, it is going to trigger further sell stops and profit taking.


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