We have a good example Tuesday morning of how the biggest bounces occur in the worst markets. After being pounded on Monday, the indices are seeing a sizable gap-up open on Tuesday morning.
There isn't any surprise news that is driving the move. It is simply the realization that the Evergrande Group crisis should stay relatively contained and really isn't a justification for aggressive selling in most U.S. stocks.
The primary reason this market has been going through a corrective process for a couple of weeks now isn't that there was some major change in fundamental factors. It was simply the cyclical nature of stocks combined with negative seasonality and technical conditions such as overbought readings. One of the main reasons that the indices sold off was that they did not reflect what was going on with the majority of secondary stocks under the surface.
As I've been discussing for many months, this has been a two-tiered market since February. While a great number of stocks were in deep corrections and even bear markets, the indices were trending higher on the backs of a small group of big-caps. The pundits and experts in the media were barely aware of what was occurring, and many talked incessantly about how the market was technically extended. That wasn't the case with most stocks, but the indices need to align better with the majority of stocks. The corrective action over the last couple of weeks has helped that to happen.
So now what? Is this correction over? Will stocks head straight back up and forget what happened on Monday? It is possible. The market has had an inclination toward V-shaped moves in recent years after undergoing corrective action. Technical traders generally look for retests and failed bounces before a bottom is formed, but that has been less frequent in recent years due to liquidity flows and the help of the Fed.
It is very likely that the market is anticipating some positive comments from the Fed on Wednesday afternoon at 2 p.m. ET. It is almost certain that Fed Chair Jerome Powell will reassure U.S. markets that it is fully prepared to deal with any fallout from the Evergrande crisis. This is exactly the sort of thing that the Fed does very well, and the market knows it.
Do we rush in and start buying the stocks that were hit hard Monday? As I've discussed, the best approach is incremental. Identify your favorite names and then look to slowly accumulate them as they develop. The biggest mistake that many traders make is to buy into the teeth of a decline and buy too much, too fast. That makes them more likely to make emotional sell decisions if their stocks act poorly.
What is most important right now is that the lows that were hit on Monday afternoon hold up and form technical support. If those levels fall, that will trigger a new round of selling, but currently, the market is optimistic that there is a potential bottom in place, and traders are stepping up to buy.
A big bounce after the ugliness on Monday feels good but don't be too trusting. The longer it holds up, the more likely new buyers will jump in, but there are plenty of trapped longs that will look for opportunities to cut back exposure if there is more weakness.