Should We Believe in this Rebound?

End of Day Update:

The S&P500 slipped modestly Tuesday, but there is nothing unusual about pausing and catching our breath after a two-day, 90-point rebound. Volume was near average, showing few were concerned about this sideways churn.

Friday morning U.S. stocks were punished when employment missed expectations, but moments after that weak open prices launched an explosive rally that pushed us back to the upper end of the trading range. At this point it is hard to say if traders bought the dip because bad news is still good, if the bad news was less bad than feared, or if people were following the herd and buying because everyone else was buying. The difference is critical because knowing who was buying and why they were buying tells us how sustainable this rebound is.

Chasing and short-squeezing are two of the least sustainable forms buying because these are a short-lived phenomena. These buyers don’t believe in what they are buying, they are simply reacting to what everyone else is doing. And as soon as the wind shifts, so will their trading. On the other hand, buyers who were excited about bad news delaying the Fed’s rate-hike are also misguided. We are deep into the region of diminishing returns where additional easy money will have little impact on prices. We need real economic gains to fuel the next rally leg. Delaying a 0.25% rate increase by a few weeks isn’t going to help corporate earnings or the economy. We already saw this realization when the Fed’s “no hike” decision lead to the most recent 100-point selloff.

The last possibility is less bad than feared. This 10% correction was driven by fear of a global slowdown taking us with it. The logic assumes a strong dollar and weak overseas demand would crush our export economy. But so far the data isn’t supporting this correlation.  Europe and Asia have been slowing for quite a while, but have yet to make a serious dent in our recovery. Without a doubt these are headwinds we have to fight against, but they haven’t been substantial enough to reverse our growth or hiring gains. The latest data points continue showing growth and hiring, meaning maybe things are not as bad as feared.

The first two reasons to buy this rebound are deeply flawed, but the last one is the real deal. While it is hard to get in traders’ heads, how the market acts in coming days will tell us who bought and why they bought. Chasing, short-squeezing, and buying bad news are all flawed trading decisions and if this bounce was built on that type of foundation, it will crumble within days. On the other hand, if traders are growing increasingly confident in our economy as they realize the fallout from a global slowing isn’t as bad as they initially feared, they will start buying with increasing conviction. That will show up in stable, supportive prices near 2,000.

The most constructive behavior we could see over the next couple of weeks is overseas selloffs that are met with a shrug when they reach our shores. No longer reacting to foreign weakness tells us this story is priced in and we can stop worrying about it. That will be our sign to jump in and ride the year-end rally back toward recent highs. But if we cannot hold recent gains, then we’re not ready yet and undercutting August’s lows is a very real possibility. But not to fret, this is just another opportunity to buy stocks at cheaper prices as we form a double-bottom.

Jani

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