The Second Bounce Matters Most: SPY, DIA, QQQ, IWM

January 08, 2016, 12:10 pm ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

In my opinion, we're going to have to deal with market declines all year, not consistently of course, there will be ebbs and flows, but volatility will absolutely be high and the probability of a market crash is as well, as I have already discussed and outlined.  The rationale for that is not as important to this article, however, because this article is intended instead to help you understand what it will take for the market to bounce after having been decimated. 

So far this year decimation is exactly what has happened.

• SPY down 5.3%
• DIA down 5.7%
• QQQ down 6.2%
• IWM down 7%

I'm speaking from experience, because Stock Traders Daily has survived and reasonably thrived during every major market collapse since 2000.  Our proactive strategies did extremely well during the Internet debacle, during the credit crisis, and during the up-periods in between, so we are seasoned enough to know what to anticipate after markets fall aggressively.

The first part of this is relatively obvious.

When markets fall aggressively investors get scared, many of them wish they sold before the decline, and a certain percentage of that population makes conscious decisions to sell if the market bounces back.  This is very important to recognize because it is this factor that often causes the market to go through a process of reversing after declining aggressively.

Declines rarely happen for no reason, so news is always a factor, but given the lack of demand for new investments in our economy as I have outlined in my Outlook for 2016 even minor negative news events can hit this market hard in the year to come.  It is a supply and demand issue, and that will lead to volatility, and volatility leads to opportunity.

The process of stabilizing is a key factor.

In order to recover after declining aggressively the first step is to stabilize.  This happens typically after the market has reeled on the heels of negative news, and possibly even on a day were some positive news exists and the market attempts to increase.  The attempt at increasing, given certain pent up desires to sell as discussed above, typically is beaten back, and the market looks prepared to decline all over again on the heels of good news.

This is where the stabilization comes into play.

If the market fails to stabilize on the heels of good news the probability of a bounce will be low.  It clearly won't be impossible, the market can bounce in that condition as well, but we're talking about probabilities here and the probability of a market bounce after a failure to increase on the heels of good news is low.

I will be more specific

The first bounce that happens initially after the market has reeled is rarely a bounce that holds because of the pent up desire to sell that might exist, so it is the second bounce that matters.

After those Sellers have come in and hit the market on the heels of the first bounce and the market falls back, typically back into negative territory again and reinvigorates the concerns, it is the bounce that might happen then, the second bounce, that has the most meaning.

If the market can hold the second bounce it will be extremely positive for the days ahead and suggest that the market recover substantially from the declines it has experienced.

In conclusion, in the year ahead we should expect the market to experience aggressive declines regularly, and we should recognize that the recovery from declines will not usually be clean.  There's a process, and it usually involves the market increasing on the heels of some positive news event, getting knocked down again, and then stabilizing and recovering from there.

That process is important, and if the market stabilizes after the second bounce the days that come immediately ahead will probably be positive.

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