As the Market Dips, Where Are the Buyers?

Many investors like to view themselves as contrarian thinkers. Knowing that the popular, crowded trade offers little room for gains, they look for ideas that are correct, yet unpopular. By taking a position that reflects wisdom that others have not yet seen, when the market eventually realizes these views are correct investors receive both monetary gains and the satisfaction of moving ahead of the pack.

Although this approach is attractive, it is also tricky because it fails to account for the role of emotion in investing. Despite modern financial theory's reliance on unemotional investors acting in a rational way, people are often swayed by their environment and what they are witnessing. We may try to reduce outside influences over our decisions, but conquering this inherent bias is difficult.

A perfect example is the recent performance of the Dow Jones Industrial Average (Dow). On June 12, the Dow closed at 8,799. This value was above its 200-day moving average (MA), and finally put the Dow in positive territory for 2009. Most investors deduced that the technicals were strong, valuations reasonable, and future gains likely. However, with the Dow 34% above its March low, people were wary of chasing. If only prices would pull back 5 to 8%, this group was convinced they would buy the dip and ride prices even higher.

That dip has now occurred. Twice in the past six trading days we have seen large drops where down volume was over 90% of total volume. These 90% down days are typical of panicked selling and have quickly delivered the buying opportunity many hoped for just 10 days ago. With the Dow now resting below its 50-day MA, the question becomes whether people will actually buy the dip or continue heading for the exit.

Handicapping the odds of buyers emerging after a 5% drop may appear to be overly sensitive to small price moves, but I believe it is essential. Since the bear market and credit crisis gained momentum after the Lehman Brothers bankruptcy, psychology has mattered much more than hard data. Stock and bond prices swing wildly as investors gauge their emotions and react to news. Since March, we may have seen some incremental improvements in the economy, but nothing that suggested a 34% rally over three months was justified. Instead, the move from abject fear to unbridled hope serves as the backdrop. Were this mood to shift again, the damage could be swift and devastating.

As we watch the market over the next few days, I am awaiting the emergence of buyers. Were they to surface, it would signal that people believe the momentum of stocks will go higher and the psychology of the rally is intact. However, were prices to continue moving lower over the rest of the week, fear is likely returning and the mood is shifting.

From its outset, I have never trusted this rally. The economy may be moving from horrible to bad, but the move from bad to good remains years into the future. Many stocks I watch are showing topping patterns and breaking lower. Should the rest of the market recognize this pattern, we could see a rush to the exits as investors believe lower prices are in the future. Just as joyful outlooks can lead to higher prices, mass fear can take prices lower.

For investors, the next few days are critical. If the Dow can successfully bounce above its 50-day MA or stabilize, investor optimism will build. However, should prices move toward 8,000, we will quickly see another 500-point drop, and the risk of retesting the March lows will increase. While I would like to think rational investors would not allow their emotions to swing so wildly one week to the next, the shifts are to be expected. By assessing the meanings of market actions, we can break this pattern and allow ourselves to react appropriately to the market's moves.

Comments

[Moon Kil Woong:]

Low volume typically is not a sign of a healthy market. The only thing worse is high volume on a falling market which can lead to panick.

Given the state of the economy and the balancing act the fed and treasury are doing between rising rates, falling dollar, and the threat of inflation versus and a falling economy, rising bad debt, failing banks, and weak real estate, I suppose we should all be very happy about low volume.

Forget green shoots, I'm just hoping there's no forest fires.

Jun 25 06:01 AM

[jeandit75:]

I kind of find it funny to read the technicians always talk about how critical are the next few days for market direction. You guys are trying to detect the fly's direction (i.e. short term) that is flying ahead of the elephant (i.e. the longer term - super recession if not depression driven market) . I think you'd rather watch that elephant before it steps on your foot.

Jun 25 07:04 AM

[rperrin:]

What nobody seems to be talking about is Waxman-Markey. Positioning ourselves for the vote Friday, is there a Cap-and-Trade trade, and if so, what is it? This vote is likely to trigger a sizable move up or down.

Jun 25 07:17 AM

[User 357705:]

The 90% down reflects the banksters and insiders dumping their shares as they see the bigger down coming. As for buyers, why would you think anyone would want to buy what Wall Street is selling after the major screwing we've gotten from it?

Jun 25 07:40 AM

[Mad Hedge F...:]

Maybe there aren't any. Now that we are solidly into a correction, I have been flooded with requests from readers to call the next bottom in the S&P 500. Well here it is. Brace yourself. Put it on a Post-it-Note on your computer. It is without a doubt and unquestionably going to be 880, 850, 830, 800, 750, 666, or 320. That last number works out to be 90% of the book value of the S&P 500, which was the low seen in the 1930s depression. Yes, that depression, not this one. You are really asking me to solve a one billion variable equation, because that is the number of direct and indirect participants in global stock markets. If the few green shoots out there start to die off, the meltdown in commercial real estate accelerates, the Fed missteps by draining liquidity too soon, or there is another unforeseen shock to the system, then you can go with the lower of these numbers. If we are distracted by the health care debate, emerging market economies continue to perk up, and this strength helps our technology stocks stay alive, then sleepy narrow trading ranges will dominate, and the higher support levels will hold. But no matter what happens, I will be able to come back to you in three months and claim that I was right.

Jun 25 08:42 AM

[Old Trader:]

It looks like we're returning to the recent days of "last bad equals good". Given unsettled fundamentals. putting it mildly, its no wonder investors have been a bit shy at "buying the dips".

One mildly bullish sign is the action in commodities, although its hard to separate how much strength is actually demand, vs. speculative buying, vs. an inflation hedge. A couple of months ago, I made a comment regarding oil prices (when the current run up was about at its midpoint), that a price of between $60-$70/bbl. might be a "sweet spot" of sorts. High enough to return some health to the energy sector, without be so high as to choke off any potential economic recovery, no matter how weak, or drawn out it might end up being.

Jun 25 05:28 PM