The market suffered significant technical damage on Monday and for the first time in 2019 the major indices are now in a technical downtrend. A combination of higher volume selloffs and breaches of key support levels has pushed the indices below key moving averages and is producing downside momentum.
Although the technical picture has turned negative, that doesn't mean that stocks are going to go straight down from here. What it means is that the risk of further downside has increased -- and that it is necessary for us to take stronger defensive action to avoid losses.
Here are a few things to keep in mind when the market has fallen into downtrends:
- Market players will be more inclined to sell into strength in order to escape positions that are causing them stress. If they can break even or reduce recent losses, they will do so, which is why overhead resistance levels matter.
- The biggest bounces occur in poor markets. Markets that go down like this one did yesterday tend to produce very big and fast bounces, as traders rush in for quick action and optimistic bulls try to catch a bottom.
- Downtrends develop as bounces fail and recent lows don't hold. Stops will be set at yesterday's lows and there will be another wave of selling if that level is breached.
- V-shaped recoveries have been quite common in recent years due primarily to the way computer algorithms operate, but they are not reflective of normal human emotions. After a market breakdown, there is usually an inclination to escape rather than jump in and add more long exposures.
- Technical traders generally don't trust the first bounce after a breakdown. They look for a technical follow through day at a later point to mark a market recovery.
The bounce this morning is very likely to produce a sigh of relief among many market players and cause some to believe that the worst is over. That is possible, but it is bad bet at this point.
The market will have to prove that it can hold above yesterday's lows. If it can do that, then more confident buyers will start to inch back in. The longer the market holds support levels, the more buyers will be inclined to jump back in.
Action like yesterday's tends to be very correlated and sends stocks down in tandem. There is no real effort to separate the quality names from those that may deserve to be sold. Individual merit of stocks is ignored when there is panic action, but as emotions die down that is where the best opportunities lie.
The best way to deal with downtrends is to first raise high levels of cash and cut losses and then to engage in selective stock picking as stocks find support. Don't be too quick to believe that the worst is over, but be ready to incrementally buy some of our favorite stocks. It is paramount that you keep a tight watch on things but counter-trend bounces can offer some of the best trading for aggressive traders.
I'll be watching to see how well this opening bounce holds and will be working on identifying stocks that I want to build as conditions evolve.
Don't be in a rush to chase this open. It is possible that we have seen the lows but that is not a high odds bet.