Just as you can’t judge a book by its cover, it’s foolish to look at stock prices, alone, when assessing the state of the market.
Internal strength, or weakness, is generally revealed when you dig a bit deeper. That helps us determine whether the current trend has the legs to continue, or is due for a sudden reversal.
Let me illustrate…
If you look at price alone, the S&P 500 seems to have hit a weak spot. It’s summer, so this is somewhat to be expected. And there’s the “Fed taper” hurdle… simple worry that the punch bowl won’t be quite as full as it has been (just by a ladle or two).
Yesterday, traders rummaged through the Fed’s July meeting minutes in search of clues. U.S. markets traded down, closing in the bottom quarter of their daily ranges. This brought the S&P 500’s loss, since the beginning of August, to 3.9%.
Cause for concern? Or a dip worth buying?
I’ve peeked “under the hood,” and I see signs of strength. So I think this is a dip worth buying.
I have three reasons… here’s the first:
This chart shows the S&P 500, with the advance/decline ratio on top. This ratio, which I’ve shown before, compares the number of stocks trading higher to the number of stocks trading lower.
Over the years I’ve found a reliable pattern here: Rallies are kick-started when the advance/decline ratio moves above four, meaning four stocks are going up for every one going down.
This happened recently…
The market lost nearly 6% from May 22 to June 24. Then, just three days later, the advance/decline ratio spiked to 4.9. This spurred a rally that added 6.1% in just 25 days. (The same thing happened in April, too.)
TODAY, I see the same spike… four stocks up for every one stock down.
So that’s one sign of internal strength. I see two more…
Second is the discretionary/staples ratio (XLY/XLP). This ratio made new highs today, confirming investors’ preference for higher returns (and the stomach for higher risk).
Third, the small cap/large cap (IWM/SPY) ratio also made new highs today. This confirms investors are in an aggressive mood and will accept higher volatility from small cap stocks in return for the promise of higher gains.
Taken together, these three signs of internal strength suggest the market is in the process of shrugging off taper talk.
I’m watching for new highs on the horizon.