S&P 500: Why You Should Buy The Dip

Jan.23.13 | About: SPDR S&P (SPY)

From mid October to mid November, the S&P500 moved down 120 points. Ostensibly, the primary reason for the weakness was the possibility of Congress unable to reach a deal which would result in spending cuts and tax hikes. Since November 16, the stock market has been on a tear with the S&P 500 gaining 150 points in about two months time. In this article, I provided my reasoning for a reversion to the mean move higher amidst this bearish climate. This rally has been very strong in terms of breadth which I noted in this follow up article, a key component in my argument for all time stock market highs in 2013.

The catalyst for this move higher was essentially the resolution of the fiscal cliff talks as Congress chose to "kick the can" down the road rather than dealing with the messy reality of significant spending cuts or tax hikes required to deal with the severity of the debt.

At least in the short term, "can kicking" has proven to be quite bullish and not excessively inflationary, much to the chagrin of the doomsayers. I do agree that in the long term, the consequences of avoiding difficult choices will create even bigger problems, similar to how the Fed's sustained low rates following the bursting of the tech bubble planted the seeds for an even bigger crisis in 2008.

However, I also believe that the full effects of the Fed's aggressive interventions have yet to be felt. And with inflation remaining tame, there is reason to believe that the Fed may step in again. Some of the big winners in the market over the last decade have been those who have successfully anticipated the adverse effects of government action on both the long and short side. This time around, I am expecting precious metals to be the biggest beneficiary of global central bank liquidity programs.

Despite these longer term concerns, in the present moment, the market trend is clearly up. In this article, I want to further my argument that this rally is not to be faded. Instead, I advocate using future weakness as an opportunity to increase exposure. Of course, in the short term political posturing and earnings results may create headline driven sell offs but I expect the market to remain resilient over the intermediate term.

Overbought Market

No doubt, the market is overbought. This is illustrated by looking at the headlines of any financial website. The two charts below show how overbought the market is on a 5 year timeframe:

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Both charts are a measure of bullish sentiment within the indexes and serve as a crude overbought/oversold indicator. My interpretation of these charts is that the market is quite overbought especially given the strong price advance in such a short time.

In certain environments, overbought conditions lead to nasty corrections. In times of excess liquidity and strong breadth, overbought conditions can persist. Most of the gains since the 2009 bottom have come in these types of trending, slowly grinding markets within the confines of an overbought market. If I am wrong in my diagnosis of the pent up demand and liquidity sustaining a strong uptrend, then this is an abysmal time to be buying stocks.

Of course within an overbought condition, there will be corrections. I think these corrections will be an apt time to add exposure. So far, the market has not given traders such an opportunity beyond very brief bouts of weakness.

Intermarket Indicators

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This chart of the equal weighted S&P500 (NYSEARCA:RSP) paints a much more bullish picture than the market cap weighted S&P 500 and is already at all time highs. The equal weighted index has already surpassed its all time high, while the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is about 5% lower from its all time high.

In my opinion, the equal weighted index can provide insights on the resilience or weakness of trends, especially when it deviates from its market cap weighted measure. Currently, it is signaling a strong market.

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This chart supports the conclusions of the previous chart as the iShares Russell 2000 Index (NYSEARCA:IWM) has also broken out to all time highs. The small caps are notoriously prone to huge swings as they are most leveraged to the domestic economy. Therefore, slight shifts in perceptions can have huge impacts on their prices. Since the November "Reid, Pelosi, and Boehner bottom", this index is up an astounding 18%.

This performance following the successful resolution of the fiscal cliff and the looming agreement on the debt ceiling is a vote of confidence for the domestic economy.

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This is another chart displaying optimism in the economy as cyclical stocks are strongly outperforming.

Conclusion

I believe many "weak hands" were taken out during the fiscal cliff fueled November sell off. However despite the price weakness, market internals remained resilient giving me confidence that ignoring the news and buying would be rewarded. Strong market internals in the face of price weakness is a sign of accumulation, and I think this steady advance higher is a consequence of that accumulation coupled with diminished supply and oversold conditions due to the political uncertainty.

Going forward as long as the internals remain strong and leading price, I remain bullish. Further, previous advances of this nature have ended with price climbing higher and internals weakening for weeks if not months as the number of stocks participating in the advance, thins.

The contrarian in me notices the excessive optimism permeating the mainstream media and sentiment surveys. Historically, buying when the "crowd" is this excited about stocks is not a good idea in the long term. Therefore, some weakness to temper enthusiasm and shake off bulls and suck in bears should be expected at some point. However, I think this weakness will be a good entry point, given that market internals remain constructive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.