The stock market staged a minor rally last week, but don’t get too excited yet; the buying support was largely triggered by a technically oversold market, rather than solid fundamentals or a fresh catalyst.
What I can say is that investors need to be careful with the high-beta stocks that are extremely volatile at this time and vulnerable to downside selling.
Just because momentum surfaces, it doesn’t mean the risk is dissipating. It’s simply an oversold bounce that could continue or falter again.
The fact that the Dow Jones Industrial Average and S&P 500 recovered their 50-day moving averages (MAs) last Tuesday is positive, but it doesn’t mean the worst is over.
I see the NASDAQ and Russell 2000 were still down more than seven percent as of last Wednesday and below their respective 50-day MAs. In fact, the Russell 2000 is within reach of testing support at its 200-day MA. This time around, we could see a bigger stock market correction, based on my technical analysis.
Until we see some sustained calm return, there could be continued selling pressure in the stock market, especially with the smaller high-beta stocks and large-cap momentum plays.
The most critical point to understand is that you need to preserve your capital base. The reality is that avoiding a loss is just as good as making profits. Imagine letting a losing trade run and before you realize it, the position is down 20%, 30%, or more.
This is especially true with the small-cap stocks. Making up ground following a major downside move is not easy. For instance, say you have a $10.00 stock and it declines 30% to $7.00. If you decide to hold on to the position, thinking the stock will rebound, the stock would need to rally 42.8% in order for you to get back to the $10.00 level.
Yes, the stock market could ramp higher, but I feel the upside resistance and bias to sell will cap any major upward push at this time. Consider, too, that the worst six-month period for the stock market is coming up, from May to October.
Don’t forget: we are into the fifth year of the bull market.
And as the Federal Reserve continues to rein in its monthly bond buying, bond yields will be pushed higher—and this cannot be good for the stock market.
We also have the crisis in Ukraine and the stalling in China. Gold could benefit if a civil war emerges in Ukraine.
Who knows what will really happen? We don’t have a crystal ball to see into the future.
Take some profits off the table should the stock market continue to rally. Moreover, adhering to a stricter risk management strategy is key. An alternative to selling may be to buy put options as a hedge against stock market weakness.
This article How Last Week’s Mini Rally Is Reshaping My Investment Strategy was originally published at Daily Gains Letter.