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Deprogramming the Cult of the Retest

Everyone's calling for a retest of old lows. Maybe it's already happened.

With stocks' big rebound, analysts predictably wonder if a retesting of old lows is inevitable. But as is always the case when market expectations are running high, the notion of a certain retest is worth treating skeptically.

A retest is a psychological event. After a sharp jog lower, stocks have inevitably bounced back, perhaps because short-sellers are buying back the shares they borrowed, or because traders are out to make a quick buck, or perhaps because dip-buyers are adding to positions on blind faith. But sometimes the buying is more substantial than that. Sometimes there are honest-to-goodness investors who are behind the bounce -- people who believe valuations have come down to a point where buying stocks and holding on to them is reasonable.

Over time, theoretically, the shorts cover, the traders take profits, the dip-buyers cave and stocks fall anew. But if actual investors were involved in the bounce, they will buy again as stocks approach the old nadir. If the buyers have adequate firepower, stocks will rise again and stocks will, in the parlance of technical analysis, have passed the retest. If investors lack the reserves, or if they weren't buying to begin with, or if their past confidence falters, the market will fall past the old lows and keep dropping. The retest will have failed.

You can easily apply this reasoning to the current situation. Following the Sept. 11 terorist attacks, the market sold off hard, with the benchmark

S&P 500

dropping 13.6% to an intraday low on Friday, Sept. 21. Buyers came into the market at the tail end of that day, kept on buying the following Monday, and have mostly kept on buying since then.

Yet all the while, technical analysts have been warning about a retest -- an idea that falls in neatly with what's going on in the geopolitical scene. There's a lot of event risk out there -- alliances could fail, new attacks could occur, badly beaten confidence could further wane -- and it is natural to think that investors could soon be hunkering down again.

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Moreover, technicians note that trading volume on the way up, while high, was not as great as it was on the way down. A textbook bottom isn't supposed to look like that: Volume is heavy on the downside because people are afraid of losing everything, and then it's heavy on the upside because they are afraid that in selling they have committed a horrible mistake.

"We got a big day up, but not the volume," says Hilliard Lyons, technical analyst Richard Dickson. "That did not meet the criteria of a capitulation day. I think we have another downturn coming. Sooner rather than later."

But heavy expectations for a retest may mean that the retest never comes. Many are holding off on buying stocks now for fear of that inevitable downturn. But if they are not in the market, then who are the weak holders these days? Who is it that lacks the fortitude to hang onto stocks even as the world shakes around them?

It's a possibility that, even though he believes that a retest probably will occur, Bollinger Capital head John Bollinger believes investors need to at least consider. Perhaps this latest selloff, he says, "was in fact a retest of the April lows."

A downturn doesn't need to stop before hitting the old lows for it to be a successful retest. Often the market is in such disarray that stocks will fall right through the old levels before bouncing back. In the fury of selling in early October 1998, for example, the

Nasdaq Composite

slipped below its late August low point.

Yet this constituted a successful retest. Investors might have known it was right to buy, but they couldn't muster the firepower, at least initially, to counteract a market that was dealing not just with fear, but forced selling from badly positioned hedge funds. After Oct. 8, and despite numerous predictions of more selling, the Nasdaq turned higher and never looked back. Investors who had reckoned on a fresh downturn were first left in the dust and then forced to chase the market higher.