The S&P 500 tumbled Wednesday after a rating agency downgraded US debt.
We traveled this road 12 years ago, the last time US debt was downgraded. That 2011 episode launched a meaningful, multi-month selloff in stocks. Are we in store for the same thing this time? No, probably not.
Novel events trigger fear and uncertainty because no one knows what is going to happen, and with nothing to go on, people often fear the worst. But since we’ve already been down this downgrade path, there will be far less uncertainty this time.
Less uncertainty = less anxiety = less impulsive selling.
But just because we won’t fall into another spiral of impulsive selling doesn’t mean this event cannot drag down equity prices over the near term. The market experienced a whole lot of ups lately, and no matter the reason, these lofty prices left us vulnerable to a very routine and even healthy step back.
As I wrote on Monday:
At this point, I’m looking at 4,600 as a tipping point. Either we keep going higher, or we don’t. If the rally resumes later this week or next week, I will buy back in. But if the market is finally ready to take a break and cool off, I’m happy to short the step back to 4,400 support.
There is no way I could have predicted this debt downgrade, but when stocks are this elevated, the next wave of selling is never far away.
Now that we have a potential catalyst to kick off the next wave of profit-taking, it is finally time to start challenging “too high.” Remember, smart traders never short strength, we wait until that strength starts crumbling.
Savvy traders were shorting Wednesday morning’s weakness. By getting in early, our stops are already adjusted to our entry points, making this a low-risk trade.
By being proactive, we limited our risks. If we are wrong, we won’t lose much. But if we are right, there are a whole lot of profits headed our way. Low risk and big rewards are the trades we dream of.
If the selling continues on Thursday, we can add more to our short position and lower our stops, giving ourselves even more protection.
On the other hand, if prices bounce above Wednesday’s intraday highs, it is time to start pulling off our shorts. And if we rally back to Tuesday’s close, the selloff is already over, and it is time to start buying the bounce.
I still think this weakness has room to run, and 4,200 is a very realistic target. But I’m not married to that outlook and will change my views as soon as the market proves me wrong by bouncing back near recent highs.