The stock market accelerated its downside move yesterday and is now deeply oversold. Such oversold conditions usually trigger some type of a bounce – and we’re getting a big bounce today. The nature of this bounce will give us some clues about the market environment, but it is what follows that bounce that will really be important.
Downtrends are made up of strong down-legs interrupted by weaker up-legs. When the next up-leg in the stock market develops, it will establish a trough that will mark the bottom of a strong down-leg. It is highly unlikely that the first up-leg following that trough will erase all the drawdown of the current down-leg. That means we will likely end up with a weaker up-leg following the current strong down-leg. What happens after that will determine if the current correction morphs into a significant downtrend.
The trough formed by the next up-leg is the key. That will be very important support. If it is subsequently penetrated in a decisive manner, we can logically conclude that the stock market has completed a significant topping pattern and established a downtrend. If the stock market holds above that trough, we will have to watch and see if a pattern of stronger up-legs interrupted by weaker down-legs (an uptrend) reemerges.
Most junk bond funds declined modestly yesterday. That is not surprising since junk bond funds typically follow the major trend of the stock market, but with a lag and with little of the day-to-day volatility. These funds may move lower again today – even if the stock market rallies. That is the lagged effect that helps make these funds so easy to time. We shouldn't worry about a small decline. I have moving average stops in place to protect us from the downside. With junk bond funds the day-to-day volatility in the stock market can be ignored in the short term. If stocks have topped and entered a significant downtrend, we may start to hit some sell stops in junk bond mutual funds in a week or two. If the correction in stocks is about over, junk bond mutual funds will likely turn higher following a modest decline.
We can’t control what the market does, but we can control how we react to what the market does. Being invested in junk bond and similar mutual funds, there is nothing to do at this point except to make sure you have stops set.