By Lucas Downey, Contributing Editor, TradeSmith Daily
When it comes to stocks, it's not where we are that matters… it's where we're going. In other words, we should focus less on today and more on tomorrow.
Here's why I tell you this…
After a monstrous rally, markets are finally stalling. Year-to-date, the S&P 500 has gone nowhere with a negative 0.03% return.
We have to wonder: is this latest tug-of-war in stocks the beginning of a pullback?
Based on my favorite indicator… I believe it is. And if I'm correct, history says we should expect market weakness in the weeks and months ahead.
The basic game plan is simple: Expect weakness in the first quarter before a lift into year-end. That means now is the perfect time to set up your "buy the dip" list.
And today, we'll study the one indicator that can help us determine the best time to buy the dip I see coming.
You'll want to read today's TradeSmith Daily closely. It's a bona fide investment blueprint for the next two months…
Think back to science class from high school. There I'm sure you learned about Newton's third law, which states: for every action in nature, there is an equal and opposite reaction.
This applies just as well to physics as it does markets.
Traders buy and sell stocks every day. Sometimes those actions get extreme… setting up for a big move in the opposite direction.
Whenever this happens, and the crowd is leaning heavily to one side, you must prepare for an eventual snapback.
Back then, I introduced you to the Big Money Index (BMI) — our proprietary indicator that tracks institutional buying and selling in stocks.
When buyers are in control, the BMI lifts. When sellers take the helm, stocks fall. Also important are the BMI's overbought level (over 80%) and oversold level (under 25%).
In November, the BMI signaled one of the lowest readings ever — well under 20%, indicating extreme bearish positioning.
We called for stocks to vault higher, and that turned out correct. Since that post, the S&P 500 is up 10%.
Newtonian evidence is powerful!
But today's environment shows the opposite of what we saw then…
Below, you'll notice the yellow BMI line is sky-high, with the latest reading at 90% (circled at far right):
This area is important to watch. Because once the BMI starts to fall out of overbought (below the dashed red line at 80%), stocks come under pressure.
The three leftmost white circles are a case in point. Once the line dips below the red line, it indicates sellers are in control and buyers are nowhere to be found.
Markets don't stay overbought forever… and these extremes offer powerful pivot points.
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The table below shows every time the BMI was overbought since 2009, with the forward performance of the S&P 500 from the last day the BMI was overbought.
You'll notice a few things:
The third column shows that, once the BMI reaches overbought, it tends to hang there for an average of 24 trading days… or a little over a month. Currently, we've been overbought for 21 trading days — roughly in line with history.
On average, the market is negative one week, two weeks, one month, and two months later. See the second-to-last row in the table.
Not only are the returns gloomy, but the winning percent is heavily in favor of the bears. A week after we fall below the red line, stocks are positive only 37.9% of the time. Even two months out, the likelihood of positive returns is hardly a guarantee… with it happening just 55.2% of the time. You can see this in the final row of the table.
Now let's take this study a step further and drive home why this signal is prescient.
The chart below shows how the S&P 500 performs over those same time frames on any given period versus how it performs after an overbought BMI.
In other words, the yellow bars below show the 1-week, 2-week, 1-month, and 2-month average returns for the S&P 500, no matter when you held it, for nearly 15 years. The black bars show those same returns after the BMI crosses down from overbought levels.
This is eye-popping. A falling BMI acts like an albatross around the market's neck:
This forecast further lends credence to our election-year study. A first-quarter dip should arrive sooner than the crowd expects.
But if you're expecting me to come out and say you should run for the hills, think again…Like I said up top, the idea of falling stocks means we should be prepping our buy lists for when the BMI goes oversold again.
And we should keep something else in mind…
It's true that most stocks will fall when the tide's coming out, like we saw in September and October last year.
That said, there will be leading groups that handle the volatility a bit better. Typically, defensive areas can offer ballast.
As we showed you during our election-year series, the companies with the best edge this year should be small-cap financial and health care stocks. That's where you want to focus your attention.
Also, don't discount earnings season. Standout companies that deliver great earnings beats could catch a strong bid even if the broad stock market keeps sliding.
Remember: it's not the setup today that matters…it's what you do with it when opportunity slaps you in the face.
The time to buy is not here yet, but it's coming.
We'll keep you updated on the BMI and the best opportunities right here in TradeSmith Daily, so be sure not to miss a single issue.
Regards,
Lucas Downey Contributing Editor, TradeSmith Daily
P.S. Last year, a single narrative dominated both the headlines and the returns… artificial intelligence.
Eric Fry, expert analyst at our corporate partner InvestorPlace, recently found something extraordinary tucked away within a little-known government document.
This document shows that the winners of a fast-approaching "A.I. War" have already been decided… and investors who get exposure to them ASAP could be set for a second, even more powerful bullish wave in A.I. stocks.
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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