Heed the Lessons of Yesterday's Selloff

"Character consists of what you do on the third and fourth tries."

-- James A. Michener

The most significant thing about the action in the market yesterday wasn't the giant point loss or the intense selling -- the most significant thing was that the large drop likely signals that a significant change in character is taking place.

For months the market has been chugging along steadily, with buyers stepping up every time we dipped. Fear and worry were dismissed and the primary focus was to not be left out as an ideal confluence of economic conditions and corporate growth led to ever higher stock prices. Although the market was technically extended, the momentum stayed strong and buyers were lulled into complacency.

Some will say there was no reason for the abrupt change in market action yesterday. Others will try to blame program trading or other manipulative influences.

The fact of the matter is that it's suprising it took so long to have such a dramatic pullback. It is simply the nature of markets to do things that assure a high level of discomfort for many investors. Markets are profitable because at their core they are so frustrating. If they were predictable and easy, we couldn't make so much money trading them.

The issue for us to contemplate isn't what happened yesterday but to understand how that action will change things going forward. Every major market index suffered key technical breaches. The uptrend lines were broken and if you follow the TA rulebook that means you go to cash and sit on the sidelines.

More aggressive short-term traders are going to look for a bounce in the next few days, which isn't an unrealistic expectation given the intensity of yesterday's losses. But for the longer-term investor, the focus now turns to what happens on a bounce. The true character of this market will be fully revealed on the second and third tries at a recovery. If those attempts are turned back, we will know that things have changed and that we are likely to see a downtrend that persists for a while.

Overseas the Shanghai Exchange, which triggered this selloff, managed a bounce of close to 4% as government officials attempted to calm nerves. However, that bounce didn't spill over to other world markets. They are down again across the board although the pullbacks are milder this morning. The London FTSE is down another 1% and the German DAX 0.8%.

Early indications in the U.S. are for stabilization but we have the very important fourth-quarter GDP number coming up that is likely to cause some action. Keep in mind that many longs who were trapped in yesterday's collapse are probably looking for exit points. They suffered some psychological as well as financial damage and they would prefer safety and security; that is very likely to pressure any early bounces. A strong open this morning carries a high risk of being sold aggressively.