Should we trust this rebound?

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The S&P 500 exploded higher Wednesday following the U.S. midterm election that saw Democrats take control of the House and Republicans add to their majority in the Senate. There was a little bit of good news for everyone and that put traders into a buying mood.

These gains erased a big chunk of October’s selloff. Anyone who sold defensively over the last several weeks is coming to regret that hasty decision. But that is the way the market works. Every buyable dip feels like we are on the verge of a much larger collapse. If it didn’t, no one would sell and we wouldn’t dip in the first place.

With the benefit of hindsight, it is easy to look back and see the bounce off of 2,600 support was the obvious bottom. But since this bottom was only a couple of weeks ago, it isn’t hard to recall exactly how hopeless the outlook was when we reached those lows. Traders were not excited to buy the dip, they terrified of the next leg lower. Remember how you felt at that moment and don’t forget it. That is what every buyable dip feels like.

For those of us that have been doing this a while and lived through countless dips like October, we know better than to overreact to periodic bouts of emotional selling. As I wrote on October 23rd:

“Over the last 69 years, only 11 times have prices tumbled more than 15% from the highs. We often think of big crashes like 1987, the Financial Crisis, or the Dot-Com bubble. But those events are exceedingly rare. All the other pullbacks over the last 69 years have been 15% or less. While 15% is a lot, it isn’t terrifying. And even better, all of those under 15% pullbacks were erased within a few months. Small and short. That sounds like something we can live with.”

And so far, that is precisely what happened this time. There was no real substance behind October’s selloff and that is why we recovered so quickly. The only people who lost out were the ones that overreacted to the fearmongering. That said, there is nothing wrong with selling defensively and it can even be profitable. The key is knowing when to get back in.

October 30th, the day after the market bounced off 2,600 support, I wrote a post titled “What Makes Tuesday’s rebound different”

“no matter which side of the bear/bull debate you stand on, there is an excellent chance this market is ripe for a sharp move higher.

2,700 is the next most obvious price target. But the market likes symmetry and a rebound to 2,700 doesn’t even come close to matching the intensity of October’s selloff. While we could pause and even retrench a little at 2,700 over the next few days, the most likely target for this rebound is the 200dma/2,800/2,820 region the previous bounce stalled at in mid-October. Even rising up to and above the 50dma and the start of this selloff near 2,870 is on the table.”

That was a bold prediction when prices were in the low 2,600s and it was met with a lot of skepticism, but it doesn’t seem so far-fetched after the market closed at 2,813.

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Predicting the market isn’t hard because it keeps doing the same thing over and over again. The challenge is getting the timing right. While it was nice to see this 200+ point rebound coming before it happened, what readers really want to know is what comes next.

While I’d love to say we will continue surging up to all-time highs, that isn’t how this works. October’s selloff did a lot of damage to investor confidence and it will be a while before people feel comfortable chasing prices back to the highs.

This rebound recovered nearly two-thirds of the October selloff and that is about as far as these things go before they start running out of steam. Momentum could carry us up to the 50dma and even 2,870 where this whole thing started, but we should expect demand to dry up soon.

For short-term traders, this is definitely a better place to be taking profits than adding new money. At the very least, expect prices to consolidate for a while as investors warm back up to this market. But more likely, volatility will persist and that means a dip back to 2,700 support would be a normal and healthy part of this recovery.

Anyone scared out during October’s selloff and looking to get back in, resist the urge to chase prices higher over the next day or two. Instead, wait for the inevitable pullback and consolidation over the next few weeks. Volatility is still high and that means big moves in both directions are ahead of us. But as long as the economic data holds up, the worst is already behind us.

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Jani

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