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Taking a Dip?

January 30, 2013

by Jerry Wagner

of Flexible Plan Investments

In the cold Midwest in January, the only talk of dips tends to be at Super Bowl parties or during the annual Polar Bear Club celebrations when a few hardy, scantily clad individuals jump into the frigid winter waters.

Of course, in the summer those dips are much more inviting, following which a double “dipped” cone from the ice cream parlor has plenty to recommend it.

But tune in to any financial news program or pick up your favorite financial read and you’ll see that dips are all the rage. In this case, the reference is to “buying on dips.” Buying on dips has a long and much praised history. Although it is a contrarian strategy of sorts, it is often paired with momentum strategies.

The idea is that you buy into the market whenever the market index moves counter to the prevailing trend. If stocks are moving higher, you wait for a “dip” and then you buy.

The key to such a strategy is that one must know whether the market is in an uptrend, when the dip is a deep enough dip, and when the dip is a dip worth buying and not the beginning of a bear market. Answering those questions puts you well on the way to developing a quantitative strategy for trading stocks.

Once quantified, this approach is probably a pretty good market strategy. What I don’t like is how it is being used today.

It seems like most of the commentators shouting the loudest to “buy the dips” have done little quantitative research to answer the questions posed above. They see the market moving higher and so they advise, “Wait for a dip then buy.”

The other common characteristic of these market gurus is that they missed the beginning of the current rally, having been overwhelmed by the negative news media chatter. Now they seem to be trying to save face and get on board the train before the market hits new all-time highs. Then, everyone will be asking them whether they are “in” the market. When the market hits new heights, these commentators have to be “in.” But where were they when the market was at a low point in the Fall?

The market began the current rally from a low point hit on November 15, 2012. If you check back in your old emails, you’ll see that just three days before we were pointing out that “A number of factors are lining up to support the rally probabilities.” The next week I was pointing out that the expected market turkey had not arrived.

Then in the post seasonal rallies and fiscal cliffs, I suggested a real “buy on dip” approach. I said that “…this could be a last year-end buying opportunity…”, and that “… a runaway year-end rally is a real possibility.”

Now, anyone can be wrong (or right) with a market call, and I must admit that I had some concerns when we were flat to down during the holidays. I only mention the record to point out that following the quantitative signals on a short-term, active basis can be rewarding, and that those commentators suggesting that we buy the dips are relative latecomers.

Still, what about the substance of the advice to “buy the dip”? I strongly suspect some of my readers don’t have 100% of their money invested with Flexible Plan Investments.:>) So should they heed the advice to be invested in stocks today, like the equity portion of their Flexible Plan accounts is?

Let’s find an answer by looking at the questions posed above. Are we in an up-trending market? All the tried and true indicators applied to the popular market indexes tell us that we are. The 50-day moving average exceeds the 200-day, the weekly closing price exceeds the 34-week moving average, and prices have moved higher for four straight weeks and for eight straight days.

Will we have a tradable dip? Probably, and soon. An eight-day run higher usually ends in a few down days, and more than 90% of the stocks in the S&P 500 are trading above their 50-day moving average. Over 75% of these companies’ shares are now classified as overbought, few are oversold. Such a wide spread has in the past has led to a market correction.

Source: Bespoke Investment Group

If there is a “dip,” how do we know it’s a buying opportunity and not just the first down leg of a bear market? First, because we are in that uptrend – the odds are in our favor. Of course, we all know that the odds have two sides. Even when they are 70% in our favor, they are still 30% against us, so it’s important to look beyond just one indicator, just as it is important to own more than just one strategy.

Secondly, when we examine past periods when the indicators are positioned as they are today, it seems that the dip has typically been limited to 3% on a weekly basis, and on a monthly basis it has peaked at about 10% (one out of seven occurrences by one measure).

Given that this tends to be a positive week seasonality-wise and that the positivity commences again around the 11th of February, the next two weeks may be your best opportunity to get on board the rally. Most of the indicators suggest some short-term weakness (investor sentiment topped the 50% mark I talked about last week, for example), but they also suggest that all-time highs in the stock market are just around the corner.

Source: Bespoke Investment Group

For the record, interest rates have moved higher and are now at the top of their recent trading range, and economic reports registered a net underperformance in last week’s reports (but many more are to be reported this week). At the same time, though, earnings reports have come in much better than expected. It could be one of the best earnings quarters in recent years, and reported revenues are beating expectations by an even wider margin.

The other frequently used phrase in the financial news of late is the debate about whether the glass is “half full or half empty.” My take is that if you’re going to take a dip in the pool, it really doesn’t matter.

All the best,

Jerry Wagner


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