We feel that investors should implement a “buy the dip” strategy. In other words, they should look at short-term dips as buying opportunities.
The bounce on Tuesday that started at a short-term support level on the S&P 500 looks like the kind of bounce that could send prices back above the prior highs again.
As you can see in the following chart, the S&P 500 hit 3,745, which is roughly equal to the bottom after January’s dip. And it has been rising since then as investors begin to favor risky assets again.
Transportation stocks were an important piece of evidence that we pointed to last week, and they have remained defensive during the pullback.
Historically, a defensive transportation sector has preceded a shorter correction, which is likely to be the case this time.
Buy the Dip as Tech Turns
From a technical perspective, the bounce in the tech sector and stay-at-home stocks is especially encouraging.
We have been convinced that tech was oversold almost from the beginning of the correction.
In fact, as you can see in the next chart, the relative performance between the dominant Technology Select Sector SPDR ETF (NYSEARCA:XLK) and the S&P 500 had reached a multi-month low.
Relative strength compares the price performance of one security or index (tech) with another by turning them into a ratio.
On Monday, this ratio broke below the short-term historical range, which may have been one of the triggers for investors to jump back into some of the best-performing stocks over the last year, while prices were “cheap” on a relative basis.
We started this article with a focus on technical analysis (and will end that way, too) because the fundamentals are mostly unchanged.
Earnings season was surprisingly good, retail spending is moderate, the labor report on Friday was a little better than expected and the next stimulus is on its way.
Current conditions look a lot like what traders call a “stock-picker’s” market where a focus on good value tends to do better than momentum stocks.
Two Key Factors
Although we see market activity pointing to higher highs in the short term, we still recommend trading very cautiously. Two factors continue to have us on edge.
First, the 10-year yield is above resistance of 1.5%. If growth expectations are the key driver for higher rates, then we shouldn’t be worried.
However, sentiment is split about this issue. There are other indicators in the bond market pointing at inflation expectations as the real problem driving rates, which would result in falling prices. It’s a little too early to know for sure which is correct, though.
Second, the international economic outlook is still very uncertain. It is unlikely that the U.S. will be able to sustain current growth levels if China, Japan and Europe aren’t moving in the same direction.
An imperfect but useful proxy for economic growth are stock indexes. As you can see in the following chart, the Japanese Nikkei 225 and German DAX30 are both looking fine.
However, the drop in the Shanghai Composite has only accelerated since the correction began.
This is not a red flag yet, but it is an issue we will be tracking. Prior to the Covid-19 pandemic crash in 2020, a decline in the Chinese indexes was a good predictor for whether U.S. markets were likely to follow.
The Bottom Line
We plan to maintain a bullish bias for now. Valuations are very high, but we think this is more likely to cause volatility than a sharp decline.
This is essentially what the market has been doing the last three months, so we don’t expect to change our strategy yet.
As we approach the summer months, we will continue to monitor the economic factors that still need to be confirmed before our outlook can shift toward more aggressively bullish positions.
For example, hiring and wage growth is still too slow, and we expect investors to start focusing more on that issue once this round of stimulus is in the rearview mirror.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
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