Throw Away Your Crystal Ball

 | Oct 05, 2011 | 8:50 AM EDT
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"Isn't it strange? The same people who laugh at gypsy fortune tellers take economists seriously."--Unknown

After dropping 750 points since Thursday's close, the Dow Industrials suddenly reversed and blasted 376 points higher in the final 45 minutes of trading Tuesday. There was the usual talk about some deal to save Europe, but there was no obvious news catalyst for the sudden flurry of buying.

What usually sparks this sort of action is a combination of short covering and dip buying, which is accentuated by high-frequency computerized trading programs. Once a move starts, there's a mad scramble as buyers anxiously pile in out of fear that they'll be left behind.

Moves like this are an excellent illustration of a phenomenon where the biggest and most sudden bounces occur within downtrends. Market players aren't prepared for them so the moves gain steam quickly.

The big question now is whether we build on this bounce or quickly roll over again. Generally, bounces like this see additional upside follow-through. Folks tend to be hopeful that it marked a turning point and they will try to put cash to work so they don't miss out. The fear of being left behind as the market makes a big turn is a motivating factor that can keep oversold bounces going, even when there is no real change of fundamental conditions.

Speaking of fundamental conditions, I keep seeing bullish arguments about how current conditions are quite different than 2008. The theory is that we really shouldn't worry about the chances of another major market meltdown like 2008-2009 since the economy isn't nearly as bad now and banks are in much better shape.

Maybe that is the case, and I tend to think so, but what I wonder is whether any of the folks who make these arguments and are so confident that the current conditions are different actually anticipated the carnage of 2008-2009? I suspect that many were equally optimistic back then as well. I recall reading many stories during that downtrend about why the market had to turn back up very soon as we continued to sink week after week.

My point is to illustrate how difficult it can be to predict market behavior. If anyone could see downturns coming, they would never happen in the first place, as we'd have already sold our holdings. What makes bear markets and major meltdowns so painful is that we don't anticipate them.  

Clearly, I have little regard for Wall Street fortune telling. No one has a good track record of calling all the twists of turns with any degree of precision. A few folks will be right at various times, but it is luck more than skill.

The best approach is to adapt as market conditions warrant. Respect the trends, play countertrend bounces and look for opportunities, but forget the monumental calls and glorious predictions. What makes you money is reacting quickly as conditions change.

So have conditions changed after the big spike in the final hour yesterday? No. We might have more of a bounce, and there is always a chance of more Europe-is-saved news, but we are still struggling with a downtrend and hovering around the lowest point in more than a year. Charts are still in poor shape and there is no emerging leadership. Trend traders and momentum players will never be fully invested at market turns and that is the case right now.

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