The stock market dodged a bullet this week.
Thanks to a strong, two-day rally to end the month, the monthly chart of the S&P 500 held above its 20-month exponential moving average (EMA) line – thereby preventing the triggering of a bear market signal I wrote about on Tuesday.
The S&P 500 has bounced hard off of oversold conditions, gaining more than 70 points in just two trading days. The index closed yesterday above its 9-day EMA line.
So, the short-term momentum has now shifted from bearish to bullish. And traders can look for higher stock prices in the coming days.
But, before we get too far ahead…
As much as I like seeing green symbols on my quote screen, let’s remember how deep corrections like this one tend to play out…
First, there’s the initial move lower – which is usually quite brutal and shakes investor sentiment from bullish to bearish.
Then, there’s the bounce off of oversold conditions that traps anyone who was crazy enough to sell stocks short into oversold conditions. This bounce is usually enough to convince most folks that the correction is over and stocks are headed higher again.
Finally, we get the retest of the lows, or a decline to slightly lower lows. This is when the actual bottom occurs.
That’s how things played out during the correction earlier this year. Take a look…
Based on the action yesterday – with the S&P closing above the 9-day EMA – I think we can say the first phase of this correction is over. We’re now moving on to the “bounce” phase.
The CBOE put/call ratio has been elevated for the past several sessions. Plenty of folks have been buying put options and betting on a continued decline in stocks – despite many technical indicators falling deeply into oversold territory. Those folks need to suffer a bit on this bounce. So, I think there’s plenty of fuel to boost the S&P up to our 2810-2850 target zone.
Once we get there, though, we need to be aware of overbought conditions that may signal the end of the bounce and the beginning of the third phase of the correction – which is a decline to retest the lows.
If you bought stocks into oversold conditions late last week or on Monday, then congratulations. You’re sitting on nice profits from a solid two-day rally. Raise your stops and consider trimming some of those gains.
If you missed the recent two-day move, there’s no need to panic and try to rush in and buy stocks right now out of fear that you’ve missed the bottom. The odds are that you haven’t.
Once this bounce phase has run its course, the market will come back down and either make a higher low, retest this week’s low (2603-ish), or drop to a lower low while creating positive divergence on many technical indicators.
All of those conditions will provide a better entry for new purchases rather than buying right now after the S&P has run 70 points higher in just two days.
Best regards and good trading,
Jeff Clark
Reader Mailbag
Did you buy into oversold conditions late last week or Monday? When do you think this “bounce” phase will be over?
As always, send in any trading questions, suggestions, or stories to [email protected].