The Guacamole Dilemma

 | Jul 27, 2014 | 5:00 PM EDT  | Comments
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Stock quotes in this article:

nflx

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amzn

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bidu

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fcx

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aapl

So, when the markets drop 2% to 3% -- which, as we have seen, can happen within a week's time -- is it right to buy that dip? According to the S&P 500 chart below, which dates back a year, the answer is a resounding yes.

S&P 500 -- Daily
Source: StockCharts.com

But many folks are uncomfortable that we're seeing sharp drops taking place within a few days, seeing as these corrections used to take a few weeks to occur. We could blame that increased speed on any old reason -- algorithmic traders, high-frequency trading, hedgers, ETFs or just a more informed and reactionary investor or trader.

Whatever the reason, gone are the days of buy-and-hold. Too often, this turns into hope-and-pray! So, in light of this shift, we should look for patterns and trends that are playing out regularly, find our confidence in the action and go with the flow -- and that gets us back to the question of how to assess dips, and whether we should buy on any particular decline.

Well, over the past year or so, I have found that these dips tend to be accompanied by very significant changes in sentiment.

For instance, we might see a spike and reversal in the CBOE Volatility Index (VIX), as we did July 17 and many other times since 2012. The McClellan Oscillators for the Nasdaq and NYSE might show extreme readings, ticking down under negative 100 (which points to a very oversold index). Put-call ratios often zoom above 1 in these instances, and the sentiment polls might show fewer bulls amid rising fear, as in recent surveys from the American Association of Individual Investors and Investors Intelligence. I have found that, then these all line up congruently, the best odds call for buying that dip.

Of course you might ask yourself: Will this dip be the last one? Sure, but that seems unlikely at the moment given the amount of liquidity in this market, the low interest rates on U.S. Treasuries and strong corporate profits. That's not to mention a very dovish Federal Reserve that will continue to provide accommodation.

For myself, when it comes to these buy decisions, I side with recent history. Discipline will trump conviction in most cases -- that is, we must be willing to take profits and losses according to our prior trading plan, and move on.

Among options traders in particular, if we are buyers we do not have the luxury of time. Options are currently priced cheaply due to the low market volatility -- and, assuming the trend continues, this is quite a favorable condition. But money moves very quickly in this market, and if don't position correctly when the opportunity arises, you might get trampled.

Meanwhile, we continue to live in a non-correlated market -- that is, trends in the overall market do not necessarily translate into trends among individual stocks, and that makes for a stock-picker's delight. For instance, the markets were hammered on Friday, yet some particular stocks performed well. Yes, Amazon (AMZN) was clobbered, losing 10%, and Netflix (NFLX) was off 1%. But, on the other hand, Baidu (BIDU) rose nearly 13%, Freeport McMoRan (FCX) gained 1% and Apple (AAPL) was up 0.6%.

So, again: Do we trust each dip, or is the next dip the "sucker move," the one that takes stocks down for that massive 10%-to-20% correction that everyone expects? You can sit around and wait for that -- and, much like a broken clock, you'll be right at some point. But how much time will you have wasted waiting for it?

If you're a stock-picker, usually the chart and technicals are your best friends. So let the market tell you what to do -- and, currently, the market is consolidating recent gains. So far in July, the S&P 500 has risen by a scant amount after rising 12.7% between Feb. 1 and June 30. Isn't it entitled to a break? At the same time, the Dow industrials and Nasdaq are up solidly, though the Russell 2000 is down an ugly 5%.

What's to come for August and September? I won't venture to guess, and certainly at some point the pattern will change -- and, when that happens, it could translate into entirely too much dip for our chips. But, for now, buying dips has been the right play, and it will continue to be -- until it's not.

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