Just a Correction or Something Worse?

05/27/2010 4:32 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

So, where does the stock market go from here?

US stocks are bouncing off the February 2010 low near 1040 on the Standard & Poor’s 500 index, which closed above 1100 Thursday.

Good news for anyone with money in the stock market. But what does it mean?

There are two possibilities.

Possibility #1: We’re looking at a bounce that will turn into a modest rally. That will consign the selloff from the end of April highs to the test of the 1040 low earlier this week to the ranks of corrections. The rally that began at the March 2009 lows needed a good 10% correction, so that it could build a base for another upward leg.

And that’s what we got—a painful, but ultimately not terribly damaging 12% correction in the S&P 500 index. It’s safe to buy again or stay in stocks, because the trend that was just interrupted by the correction still points upward.

Possibility #2: This is simply an oversold bounce—stocks fell so far so fast that prices brought out bargain hunters. The bounce will fade not so far ahead and stocks will resume their selloff. The downturn that began in late April isn’t over, and we’re looking at something more serious than a standard correction.

I tend toward possibility #2, but I don’t know for sure. Stocks are climbing on modest amounts of news from Europe and China that I would call “Not as disastrously bad as you thought it might be” news rather than actual good news.

It is better than it could be that China isn’t actively dumping euro, for example, but that doesn’t mean that China has resumed buying the currency. Most likely, Beijing has simply decided to hold onto what it has but not to add more, even as its foreign exchange reserves increase.

It’s better than it could be that Spain’s central bank is finally moving to do something about troubled regional banks. But the plan won’t do enough to actually eliminate failing banks in the sector. And Germany still seems committed to ignoring a similar problem with its regional banks.

In other words, the twin euro debt and China growth worries that fueled the correction are still in place and look like they’ll be with us for months yet. In that case, I find it hard to put much money behind the idea that somehow US stocks will manage to resume a strong rally without the participation of the rest of the world. (For more on this idea, see this recent post.)

Although I still believe that the US market is likely to outperform the rest of the world over the next few months, I just don’t know whether or not that outperformance will result in actual portfolio gains.

Just as I was determined not to sell in panic when the market looked worse, I wouldn’t get too giddy here, either. I still think the best opportunities in 2010 will be in emerging market stocks—and they’ll present themselves later in 2010. For more on the timing of my selling and buying strategies, see this post.)

The first test of the ability of this bounce to turn into something more lasting will come at 1130 to 1140 on the S&P 500. There’s considerable resistance at that level, made up of a 50% retracement of the selloff and the top of the Bollinger bands price range. At 1130 to 1140, stocks aren’t cheap—in the short term—anymore and investors will be buyers only if they think the future looks brighter than it did just a few days ago.

Any reading of the stock market is, of course, complicated by the long Memorial Day weekend. It would be absolutely normal for traders who made a profit today to sell on Friday ahead of the weekend to reduce their risk while the US stock market is closed.

So, don’t read too much into any selling on Friday. The test comes next week after we’ve all had our holiday and returned to work.

Full disclosure: I don’t own shares of any stock mentioned in this post.

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