Traders discussing

For investors who employ a subjective or discretionary approach to managing/trading the markets, it is now time to “place your bets.”

As I’ve expounded on recently, “waterfall declines” such as we saw for six days during the middle of August, tend to follow a fairly predictable pattern once the initial dance to the downside ends. That’s the good news.

To review, the typical phases the stock market indices go through following an emotional, volatile decline include:

  • The “Dead Cat” Bounce
  • The Retest Phase
  • The Bottoming Phase

The bad news is that it is often very hard to discern which “phase” the market is currently in without the benefit of a little 20/20 hindsight!

At the present time, I can make the argument that since time compression is definitely a thing in the stock market these days, we’ve already seen the initial decline, the bounce, and the retest, and that we’re currently seeing the beginning of the bottoming process.

However, I can also argue that everything seen since August 18 has been part of the first phase: The initial decline.

The chart below should help make my point.

S&P 500 – Daily

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Which Is It?

On one hand, it is easy to argue that with the way the algos work these days, we’ve already seen the majority of the “crash playbook” occur. First we had the initial decline, which lasted six days. Then there was the bounce, which occurred in the next three days. And then there was the retest phase, which was where the SPX tested the 1900 level twice over the next five days.

So, since everything happens faster on Wall Street these days, one can argue that it is now time for the bottoming process.

Typically, bottoms occur over time and therefore, this phase has historically unfolded over a couple of months or so. During this time, market participants “deal” with the reason for the initial decline and the “price discovery” process moves the indices up and down and back and forth until the issue at hand is no longer the focal point.

The primary argument for the market now being in the bottoming process is that since 2011, all bottoms have been V-bottoms as all the QE money has to go somewhere. And since the U.S. looks to be one of the safest places around the globe, it is a good bet that those looking to put money to work will continue to look hard at the U.S.

This argument does not mean that stocks will go straight up from here or that we will not see another test of the lows. No, the primary points of this argument are that (a) the initial decline was likely overdone and (b) there is now support for stocks when prices decline.

The bulls also contend that since sentiment has become overtly negative, that there is no inflation to speak of, that the job market continues to improve, and that the chances of a recession in the U.S. are almost zilch at the present time, this is the time to buy the dip.

Meanwhile On The Other Sideline…

However, the bears will argue that this time things are different. Our furry friends tell us to remember that there were many big picture warning flags waving before this decline began. This, they say, is a sign of a market that is ready to morph from one costume to the other.

The bears remind us that many big name fund managers have stated publicly that there are reasons to worry, with David Tepper being the latest to just that at the end of last week.

Next, we’re reminded that global growth is clearly slowing in some important places – like China. Which reminds me that a modified version of an old saw could be applicable here, “When the world sneezes, the U.S. will catch cold.”

And finally, those seeing the market’s glass as at least half empty remind us that valuations continue to be elevated. Our heroes in horns contend that the recent 11.2% drop improved this issue. But when one objectively reviews the various indicators, it becomes quite clear that the recent dive did little to impact the market’s overall overvaluation problem – at least on an absolute basis.

The Takeaway

So there you have it. If ever there was a time to “place your bets” on which way this thing will go from here, it would be now.

From my seat, I think the bull argument probably carries a bit more weight here. As such, longer-term investors should be looking to put capital to work into this type of pullback.

However, for those with a shorter-term perspective, this remains a time to exhibit some caution and to listen to the message coming out of the indicators. Which, of course, is currently more than a little mixed.

So, we will be looking for clues as to what to expect next. If the market breaks down to new lows on expanding downside volume, negative breadth, and increasing volatility, the risk of another major downleg will rise substantially. But on the flipside, we will also be looking for any move up to be accompanied by expanding volume, global confirmation, and multiple “thrusts” in the momentum indiators. Stay tuned.

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