February 2nd, 2010

Buy the Dip or Sell the Rip?

It’s times such as these that are the most dangerous and precarious for traders. Having suffered through a relatively quick and severe decline in January, it’s easy to look at each uptick as if it were the beginning of a prolonged, secure recovery. It’s a most especially risky time for those who, by their nature, are optimists or, by their financial condition or poor past market performance, are looking for quick profits.

Investors are caught on the horns of a dilemma: take advantage of the dip in prices and buy those stocks you missed on the way up or take advantage of the higher prices and sell those stocks you missed selling before they tumbled.

There’s only one observation I can offer from my own experience …. the market doesn’t necessarily move on your time schedule (everything usually takes longer than we would like) or in the direction you want or expect. While the last couples of days have been encouraging, the back of the bull has been broken and there’s a chance for a more significant correction than the one we’ve experienced so far. Here are some reasons (as of 1:00 today):

  • Is it coincidence or inexplicable magic that the Index turned south just when it touched an extremely long [resistance] trendline emanating from two pivot zones, one at the market peak in October, 2007 connected to the May 2008 correction peak. From that point forward, the housing default crises turned into the worldwide financial crises and the Index gapped away significantly from that trendline plus the moving average momentum indicators.
  • The Index is now caught in the same nauseating, narrow range where it was in Nov-Dec. Many shares were traded then so it’s logical that many would be unwound as the market returns to that level. Then the Index was held up by buyers’ demand and, by my guess, now it will be held down buy sellers’ supply.
  • The blue horizontal trendline at around 960 is the neckline of the inverted head and shoulder pattern that defined the bear market crash’s base. It’s a logical target for a “buyers’ remorse” sort of correction.
  • Volume has turned slightly bearish as the OBV turned down as volume seems to be heaver on down days than on up.

The primary reason the market’s meeting resistance, in my opinion, is that it was way ahead of itself as measured by an analysis of distances from long-term moving averages since 1963. On December 20, in “More Evidence A Correction Is On The Way“, I compared the current recovery to earlier ones:

“The current recovery has carried the Index to levels that are atypically ….When the Index was exceedingly ahead of its moving average in 1983, it went into 7 to 8 month horizontal channel of about 10% followed by a further 8% decline over the next six months before resuming the bull market. The 1997 correction was a 10%, six-month horizontal channel followed by an upside breakout and continuation of the bull market….The 1975 bull market (the market went up 45% over 6 months to July), saw a 15-17% correction to allow the 200-day moving average to catch up to the index. The Index actually saw support in that moving average and bounced off of it twice before continuing its upward momentum.”

Even though the Index has declined and the averages slowly climbed, it is still too far away from its moving averages by historical measures. Most of the time, in a normal bull market, the Index tends to be 5-11% above the moving average (the ratio if Index touches the moving averages is 1.00):

While the 200-day moving average is at the historical mean, the index is still far too above the 300-day moving average. Any way you look at it, I believe the safer course still is to be defensive; take advantage of moves up to lighten up.

Subscribe below or click here to learn more about help for navigating turbulent markets.
  • skogie

    Hey Joe, great comments. Can you explain the ratio chart a little more? Is the frequency axis telling us how often the given ratio readings occur? Thanks.

  • Joe

    Exactly, the number of times the ratio (Index/MA) occurred out of a total of about 12000 observations (i.e., trading days since March, 1963).

    Clearly, distribution is skewed heavily towards values greater than 1.00 since the market trends up 70% of the time.

    The right-hand tail represents the bear market crashes.

  • sfgirl

    Thanks for the great insight!