After U.S. markets closed on Monday, the Treasury Department named China a "currency manipulator." This designation will result in talks with the International Monetary Fund and may result in moves to eliminate unfair competition by imposing tariffs and other measures.
This news caused a sharp drop in futures, but, overnight, China claimed that it "has not used and will not use the exchange rate as a tool to deal with trade disputes." The People's Bank of China backed up this claim by allowing the yuan to strengthen and pushing it back over a key level against the dollar.
The market was pleased to see that China was not ratcheting up the currency war -- and indices reversed sharply after the yuan was allowed to strengthen.
The question now is whether yesterday's sharp selloff will be quickly forgotten. The market has consistently done a nice job of recovering from technical breakdowns such as this. Back at the end of May, there was a sharp V-shaped move that eventually led to new highs after weeks of poor action. The S&P 500 went straight back up without any retests or consolidations.
The circumstances this time are a bit different. While the intensity of the trade war has cooled off, the potential for a deal is far worse than it was a week ago. Both sides have upped their responses and there is no immediate negotiations scheduled. Some pundits believe that it is unlikely that a deal will be done within the next year.
After action like that on Monday, there is little choice for active market players but to take some defensive action. The market may reverse and go straight back up but that isn't something that we can rely on in this situation. The chances of further downside are higher than a straight-up bounce.
The key thing to keep in mind as you consider this market is that the action is mainly index driven at this time. The best vehicle to play the volatility is ETFs, rather than individual stocks. At this point, stocks tend to move in tandem as they react to headlines and the merits of individual stocks are secondary.
Market players will be focused on yesterday's low as the key technical level. If the lows hold, confidence will build and the buyers will put more capital to work. If the lows fail to hold, it will trigger more sell stops and embolden the bears.
My game plan is to wait an hour or so to see how well the market holds up. If there is quick selling into this bounce, I'll stay on the sidelines. But if the lows look likely to hold, I'll search for some incremental buys. Quite a few small-cap stocks are reporting earnings this week and next and there is likely to be some opportunities when there is some actual news to consider. I'm at about 70% cash and feel that I'm positioned well for whatever unfolds.
The biggest bounces occur in the worst markets and you can be sure that many market players will be anticipating yet another V-shaped bounce. It might not be as easy this time.