Weekly Review and Look Ahead: Should we be buying this dip or selling it?

Free Weekly Analysis

The S&P 500 retreated from all-time highs set earlier this week as Coronavirus fears came rushing back. While nothing concrete popped up in the headlines, the creeping spread of this epidemic outside of Chinese borders is concerning investors. That said, prices only retreated 2% from the highs, hardly panic material.

Is the market about to fall off a cliff? Some people seem to think so and are abandoning ship before the big crash starts. But is that the way these things normally happen? A crisis happens. The market gives us a few weeks to think about it and lock-in our profits. And then it crashes??? I don’t know about you, but in my nearly three decades of trading experience, when things go bad, they go bad breathtakingly fast. Traders sell first and ask questions later. If you stop to think, you are left behind.

This Coronavirus thing first hit markets back in mid-January. Here we are more than a month later and the crowd is still talking about it. Should we be scared? To be honest, I don’t fear things the market’s been chewing on for this long. The owners who fear these things have been given plenty of time to bail out and they were replaced by confident dip buyers who didn’t mind jumping in front of these headlines. Out with the weak and in with the strong. That’s how news gets priced in. If these dip buyers didn’t care about these headlines when they bought two and three weeks ago, what are the chances they will change their minds now? Pretty small.

Typically, the reaction to a recycling of the same old headlines get smaller over time, not larger. We have the knee-jerk reaction where traders fear the worst. Next comes the “less-bad than feared” relief rally. Not long after we hear the first echo of the initial selloff. But like most echos, the intensity falls off with each reverberation. There is a good chance we are in the middle of the first echo.

Every once in a while, like 20 years once in a while, things actually turn out far worse than feared and prices continue to tumble. That’s what happened during the 2008 financial crisis. Investors thought things were as bad as they could possibly get, yet somehow they ended up getting even worse. That certainly could happen with the Coronavirus if it spreads to the point where hundreds of millions of people are infected. Of course, if that happens, we have bigger things to worry about than this latest swing-trade. We are not there yet and we most definitely shouldn’t trade as if that is where we are headed.

Successful traders focus on the high probability events and trade them when the risk/reward lines up in their favor. If we assume this modest pullback is nothing more than pausing after rallying 200 points to 3,400 resistance and that this Coronavirus echo will be smaller than the initial selloff, we could be very close to the bottom of this dip.

While no one knows what will happen next week, when the probabilities and the prices line up in our favor, we take a chance. A lot of times we get it right, sometimes we get it wrong. But as long as we are smart with our entries and stops, the cost of being wrong is low and if we buy right, the eventual rewards are quite nice.

Over the last few weeks, the way the market went into the weekend was the exact opposite of the way it came out. A “better safe than sorry” dip Friday afternoon was greeted with a relief pop Monday morning when things didn’t get worse. The “there is nothing to worry about” Friday afternoon rally was met with second-guessing Monday morning. Today the market stumbled into the close and if this pattern holds, this was actually a decent entry point because a lot of the selling already happened. If things don’t get much worse this weekend, expect prices to pop Monday.

The best way to buy this dip is to start with a small position and only add more money once the trade is working. Keep a stop under today’s lows. If we get squeezed out Monday, don’t worry about it, pull the plug and try again. Often these rebounds fail once or twice before the real one takes off. But if we are smart about our entires and stops, getting whipsawed a couple of times isn’t a big deal. Good Luck!

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Tags: S&P 500 Nasdaq $SPY $SPX $QQQ $IWM