On Thursday, the major indices plunged as market players sold everything that wasn't nailed down. The headlines suggested that it was fear of a surge in coronavirus cases that triggered the panic, but the more likely reason was much more complex. The indices have been growing increasingly overbought, rotational action was picking up steam, and there was highly unusual speculative action in small-caps as a crop of young day traders decided that trading stocks was a new and profitable hobby.
What ignited the reversal was the Federal Reserve policy statement on Thursday. Chair Jerome Powell was sufficiently dovish and promised sustained efforts to supply more stimulus, but he also pointed out that fixing some of the problems may not be that simple.
There wasn't anything overtly negative, but it was a perfect setup for a 'sell the news' reaction to a market that badly needed to reset to some degree. Once the selling took hold, the narrative about an increase in COVID-19 cases was promoted by the mainstream news media -- and the rout was on.
The selling raised fears that the market was now in a position to drop, much like it did back in February when the COVID-19 crisis first took hold. That selloff began very abruptly following an all-time high -- just like the selling that occurred on Thursday.
Typically, markets that sell off as aggressively as this one did on Thursday produce some additional downside before they find meaningful support. Bulls that were trapped will be looking for exit points as they try to protect capital and avoid the pain of the sort of action that occurred in March.
A quick oversold bounce is not unusual, especially when there has been great success at dip-buying recently. Dip buyers are inclined to stick with what works until they suffer a series of losses. On Thursday, the dip buying didn't work at all, but they are making a very valiant try at the open again on Friday morning.
On a technical basis, what we need to watch for is a test of yesterday's lows. That will be the level where stops are set -- and if it is breached, it will raise concerns that downside momentum is building.
The technical action looks similar to February, but there is one very big difference at this point -- and that is the Fed. Back in February and March, the COVID-19 crisis created a huge amount of uncertainty. No one knew how bad the situation would be and even the Fed's initial stimulus moves didn't produce much help. At this point, the economic certainty is not as great and there is no doubt that there is still the likelihood of even more fiscal and monetary stimulus.
What created the big move off the March lows was the 'don't fight the Fed' attitude of the market. You could see how the flood of liquidity was helping to drive stocks higher without much regard for valuations, fundamentals or economic issues. That dynamic has not suddenly disappeared after yesterday. It will continue to provide support and will give dip buyers enough confidence to jump in like they are doing Friday morning.
It is an extremely tricky market right now and the prudent move is to protect capital while continuing to look for opportunities. Don't let recent gains slip away, but don't be overly negative about what the market might do next. It is a difficult balancing act and requires quick reaction and careful strategy, but it beats trying to predict what this market might do next.