Know Your Rebounds

It was nice to finally see a lift in the market. After a historic one-week decline, the equity markets sustained weakness, and better valuation parameters finally attracted some attention. The obvious question at this point is how far will an oversold rally go, near term, and what is the longer-term potential given past two weeks.

Near term: Yesterday was a solid day, but wasn't necessarily dramatic. Typically, when you get the first real rally after a prolonged period of weakness one expects more dramatic volume and breadth statistics. In other words, while advancers beat decliners on the New York Stock Exchange by a 3-1 ratio and advancing volume beat declining volume by a 5-1 ratio, a powerful rally off the lows would typically see breadth and volume breadth at much higher levels.

That said, there really isn't a great deal of selling pressure at current levels. Most traders and investors who have been buying the market during the past few weeks are so deep in the hole on their average cost that even a 4%-to-5% rally doesn't get them close enough to break-even. That limits the "cut-your-losses" selling at current levels. In addition, in order to take profits, you would have had to buy late Thursday or Friday. Few took this approach, so there is still limited profit-taking at current levels.

In plain English, not enough people have profits to sell, and most people wouldn't gain enough back to sell on one day's rally. Couple that with some short-covering and valuation-driven buying, you get an oversold, technically driven rally.

How long can this bounce last? That depends on how quickly we reach levels that would bring in the overhead supply of stock. I would venture to guess that this could happen around 8800 on the Dow and 1600 on the Nasdaq. Those levels would create enough profit-takers from those who bought after the market reopened last Monday. It is important to remember that the markets remain in a downtrend and the geopolitical and economic environment is very uncertain.

At this point, the current rally should be considered nothing more than an oversold bounce. Clearly, all rallies -- short-term and long-term -- start that way, but it is important not to assume we have made the low and are going to start an uptrend until there are real signs suggesting it. One tangible sign would simply be breaking the near-term downtrend that is in place with all the major market averages.

Long term: It's important to readjust your thinking. Prior to the events on Sept. 11, I thought that even with the weakness from the May peak, we were still in the long-term bottoming process because the lows were established in the beginning of April. Typically, when you make a low, that needs to be successfully retested as part of the long-term bottoming process. Especially after a historic bear market, there are going to be times when you feel you are wrong, but as long as the lows hold, they are part of this painstaking process.

Obviously, those lows did not hold due to the terrorist attacks. Truth be told, they appeared ready to break anyway. In a nutshell, that means we have to start the painful bottoming process all over again. There will be big up weeks and big down weeks. The only difference between now and the prior bottoming process that failed is that we have had a more climactic decline and valuations may begin attracting more institutional money from the sidelines. While that may buffer any significant downside, there clearly will be some caps to the upside over the next couple of quarters.

Economic Rebound vs. Market Rebound

First and foremost, there is a very big difference between an economic bottom and a market bottom.

The unspeakable acts on Sept. 11 made what was very uncertain about the economy turn black and white. There is very little debate among most experts that the economy is likely to be very weak over the next two quarters. There is also very little debate that the additional Fed moves and government spending initiatives should ultimately lead to a more robust economic recovery. In other words, there is an increased likelihood that a "V" bottom can take place in the economy once we get past the next two quarters.

As I said, the market must again go through the long-term bottoming process. After painful bear markets, when the public is so overexposed to equities, there needs to be time and a level for those who want to cut back to have an opportunity to do so. While a few have sold their positions and have moved money in their retirement accounts, we have gone through a time where investors were trained to buy the dips, especially the big ones. That means individual investors have an uncomfortable exposure to equities.

From a trading perspective, the market has not bounced high enough to bring out the sellers whose average cost is much higher. As we bounce, there is a huge supply of uncomfortable stock that will need to be absorbed by the market. I am confident it will be absorbed by those attracted to the lower valuation levels, but that will take time.

At some point, if Friday proves to be the low, that low will need to be successfully retested. Once that takes place and there is a transition of stocks out of uncomfortable hands into comfortable hands, a more sustainable rally can take place, especially when it dovetails with economic improvement. While the economic rebound may be a "V" bottom, any significant stock rebound is likely to be more like a "W" bottom.

Define Your Strategy

The key is to define a strategy when you buy a stock. If you buy because you thought the market went down too much, that is a trade. When the market moves a little higher, take your profit and wait for the next opportunity -- there are likely to be many of them.

If you are buying because valuations in certain sectors or specific stocks have become much more attractive, then that is an investment. The key here is to know what your goals are and what your strategy is.

Avoid making trades into investments and investments into trades. Set a plan, follow the plan and have an exit strategy.

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