- Stocks have enjoyed a big rally since mid-June.
- Sentiment isn't as favorable today as it was two months ago, and stocks are colliding with resistance.
- Using weakness to buy stocks in the second half of a bear market can pay off.
When I wrote “Is it Time to Buy-The-Dips Again?” on July 21, I expected we’d get dips to buy. However, chances to buy have been few and far between. Instead, it’s been primarily shallow intraday retreats met with buyers. This type of “lock-out” rally often happens when frustrated short sellers use every opportunity to cover or increase the long side of their book.
At the lows in June, we saw professional risk-taking at its lowest since the Great Recession. Hedge funds had finally abandoned technology stocks following a disastrous performance that put them on the hot seat with investors, such as pension funds. Individual investor sentiment readings were dismal. The volatility index was soaring above 30. The Put/Call ratio, a measure of bearish put buyers to bullish call buyers, was hitting extremes above 1; few stocks were trading above their 200-day moving average. All that pessimism, driven by a relentless media blitz of bad economic data, proved the perfect fuel for a rally.
And boy did we rally!
Some may argue that the big move doesn’t make sense, given that nothing has changed in the economy. However, that’s the usual drumbeat of ‘worry’ stocks tend to climb during bear markets.
In “The Market May Be Irrational, but That Doesn't Mean It Won't Go Higher,” Real Money’s James DePorre writes:
“The bull-bear debate is very intense right now, but even if you believe this recent action is completely irrational there is no way to guess how much longer it will persist. One of the most dangerous things you can do in a market like this is to try to time a market turn. Many market players have been doing so for weeks now, and all that has happened is that they are adding fuel for more upside…There is an old saying that the market can remain irrational longer than you can remain solvent.”
The fuel DePorre is talking about comes in a variety of forms. First, some raise cash because they think the rally can’t go higher, only to buy again when the market doesn’t cooperate. Then, the dig-in-heels short-sellers capitulate one by one as losses mount. And then, there are the offside hedge funds who scramble to buy to avoid frustrating clients again by missing the move up.
We shouldn’t underestimate how much FOMO may have come into play with these investors during this rally. Remember, the average return in the first year of a bull market is 38%. The second year's return is just 12%. And the average annual return over rolling 10-year periods is just 6%, according to CFRA. So if you miss out on the early innings, there’s a good chance you’ll end up playing catch-up if you want to beat the market. Nobody wants to be in that position.
Is it time to chase?
If you’ve been mainly on the sidelines, you may be tempted to jump in but nervous you’ll buy just as stocks lose steam. You’re not crazy to worry about top-ticking this rally.
The major indexes are entering thick resistance at their down-trending 200-day moving averages, suggesting if sellers do reappear, it could be soon. The last time the S&P 500 challenged the 200-day was in March, when it was still trending up. Then, the index got about 3% above the trendline before beginning another leg lower.
In “An Unconfirmed Bull Sighting Was Reported on Nasdaq,” Top Stocks Helene Meisler notes that sentiment is mixed and no longer as supportive as it was in June. She writes:
“So, is sentiment now bullish? In some places, it is, in others, it is not. The put/call ratio remains stubbornly high with a reading on Wednesday of .97. But the Investors Intelligence bulls are now at 44.4%, the highest since January and up from 26.5% in June. The bears are now 27.8%, down from 44.1% in June. The bears are the fewest since early February. So, essentially the bears and bulls have changed places since June.”
So, while some continue to buy protection via puts, the general feeling of participants has improved dramatically since the lows, building a complacency that’s showing up in the volatility index.
Back to Meisler:
“The DSI [daily sentiment index] is now at 15 for the VIX. As a reminder, a reading in the low teens is a warning -- think yellow light. A reading in the single digits is a red light. The extremes for this indicator are single digits and over 90. Nasdaq got to single digits in June…It doesn't always work so perfectly, but I have found this indicator very useful over the years. It takes a lot to get it to an extreme, which is why I believe it works.”
So, the VIX could be knocking on the door of extremes, suggesting higher volatility and the risk of the market backfilling gains, at least short term. Perhaps, that will give investors a more actionable “dip” to buy. But, we’ll have to wait and see.
Meisler isn’t the only one striking a somewhat cautious tone. Real Money Pro’s Doug Kass has reined in some of his early summer optimism. In this diary today, he writes, “Defensive/poor market positioning by the hedge fund community, combined with better/moderating inflation data, are combining for a degree of FOMO not seen since late last year. I expect it to be short-lived and should be faded. But I am not fighting it for now.”
And Action Alerts PLUS Co-Portfolio Managers Bob Lang and Chris Versace wrote in their early morning note to members today, “So while we enjoy the market rally and what it's done for the AAP portfolio…we just aren't out of the woods yet. And the concern we have is that the sentiment shift is getting ahead of itself. And that has us watching the 4,270 to 4,300 level on the S&P 500. And what members need to know is this. We will continue to be prudent managers of the portfolio.”
The Smart Play
I wrote in my "dips" article in July, “While I acknowledge seasonal weakness (summer doldrums) and ongoing bad news could cause another sell-off this summer (we could even undercut the prior low one more time), I believe using weakness to cover shorts, rebuild long-term positions, and increase exposure to early-stage stocks (discretionary and technology, primarily) should pay off handsomely.”
I still believe another wave lower should be bought, not sold. As I noted in that article, according to the Stock Trader’s Almanac, “the typical mid-term Election year action is a bottom in mid-June, followed by a choppy but upward trajectory until late September or early October, and then acceleration into year's end. Of course, history doesn't repeat, but it often rhymes.”
It’s best to sell during the first half of a bear market and buy during the second half. Nobody rings a bell signaling the mid-point. Still, a mindset shift toward buying weakness may ensure you’re positioned to take advantage of the next bull market if the typical pre-Election year strength repeats in 2023.
If you’re nervous about the market dropping to new lows because of ongoing economic weakness, it may be helpful to know that less-volatile recessionary groups are producing solid returns.
For example, the SPDR Utilities ETF (XLU) , iShares U.S. Health Providers ETF (IHF) , and SPDR Consumer Staples ETF (XLP) are up 17%, 18%, and 10% since the June low. Also, the IHF and XLU are outperforming the SPY this month. So, you haven’t had to go too far out on the risk spectrum to have made money during this rally. I suspect that to continue a bit longer.
As for early-cycle stocks, individual stocks bottom before the market, so it’s time to make sure your watch list is up-to-date, and that you’ve looked at individual price charts and mapped out support levels to target buys. Remember, you don’t need to buy your entire position at once. Spreading buys out over time to take advantage of the market’s volatility is wise.