Why this rebound demands restraint

Free After-Hours Analysis:

On Thursday, the S&P 500 bounced between modest gains and losses. The gov’t shutdown is dominating headlines and there is no end in sight, but the market doesn’t care and continues holding last week’s 2,600 breakout.

It’s been a wild ride from the Christmas lows, but so far the market is still acting well. Prices tumble from unsustainable levels quickly and holding 2,600 for more than a week is a good sign. Especially in the face of bearish headlines. If prices were grossly overbought, we would have tumbled by now.

That said, the last few weeks priced in a lot of good news in anticipation of breakthroughs with China and the shutdown. The problem with hope is it leaves us vulnerable to disappointment if things don’t go according to plan. While the market is acting well and trading like it wants to keep going higher, as long as we continue hovering near 2,600 support, we always run the risk of violating it. I remain cautiously optimistic, but I reserve the right to change my mind if conditions change.

But just because the market is acting well doesn’t mean this is a good time to add new money. Only a fool chases prices higher after a 10% move in a few short weeks. As I often write, markets move in waves. Understanding that principle in October, November, and December allowed us to profit nicely from sharp bounces on our way lower. And now that the market is recovering, we must acknowledge any rebound will include big drawdowns on our way higher. To expect anything different would going against the very nature of the market.

I don’t see any imminent warning signs of an impending collapse, but that still doesn’t mean this is a good time to be holding a short-term trade. No matter what happens next, the market will do something. Maybe it goes higher, or maybe it goes lower. One side will be right and the other side will be wrong. But just because the market will move doesn’t mean there is a good trade for us.

I buy when the odds are skewed in my favor. When the risks are small and the rewards large. Most of the time this happens when the market dips. Fearful sellers offer stocks at steep discounts. The more the indexes fall, the less risk there is because a big chunk of the downside has already been realized. And the lower we go, the greater the reward we collect when prices rebound.

But right now we have the opposite. The 10% rebound from the Christmas lows consumed a huge chunk of the upside. And now that prices are far more expensive, there is a lot more risk underneath us. Stocks are acting like they want to keep going higher over the near-term, but the limited upside remaining and heightened downside underneath means the risk/reward is now skewed against us.

Stocks are acting well and like they want to keep going higher over the near-term, but I’d rather be taking profits at these levels than adding new money. That said, this outlook only applies to my short-term trading account where my holding period is a few days or weeks. For our favorite buy-and-hold investments (think retirement accounts), there is no reason to sell and in fact, smart savers increased their contributions during this market volatility.

What’s a good trade worth to you?
How about avoiding a loss?
For less than $1/day, have profitable analysis like this delivered to your inbox every day during market hours

Follow Jani on Twitter @crackedmarket

Tags: S&P 500 Nasdaq $SPY $SPX $QQQ $IWM $AAPL $AMZN