Have Markets Found The Next Dip? - SPDR S&P 500 (ARCA:SPY)

What a difference a day (or two) makes in this business.

Last Wednesday, the sky was falling and the bears were adamant that this time things were going to be different. Those seeing the market's glass as at least half empty were confident that one of the longest bull markets in history was going to end.

Or at the very least, a meaningful correction (a decline exceeding 5 percent) was beginning.

This time, our furry friends had a massive technical divergence between the Russell 2000 and the blue chips on their side. This time, leadership had narrowed so much that 47 percent of the NASDAQ constituents were 20 percent or more below their recent highs.

This time, the market internals were weak. This time, Europe's economy was in trouble. This time, the Fed was talking about changing course. This time rates were going to reach "escape velocity." This time, the dollar was soaring.

Yep, this time, the bears told us, was NOT going to be just another dip-buying opportunity.

For the past two and three quarter years, #BTFD has been the name of the game. And in the last 18 months, every single dip has simply been another opportunity to put cash to work. The chart below really tells the whole story.

S&P 500 - Daily

As the chart illustrates, there have been 8 dips in the last 18 months. The first takeaway from this chart is that anyone looking to get in the game has had an opportunity to do every 2.25 months on average. As such, there has been no need to "chase" stocks higher.

This may explain why the advance has been so steady. Why bomb into your favorite names when you know an opportunity to buy the next dip is likely right around the next corner (or in response to the next so-called crisis)?

The second takeaway from the above chart is that the prior 7 "dips" have produced 7 subsequent all-time highs on the S&P 500. It is also worth noting that the majority of the previous 7 pullbacks produced oversold conditions and sentiment extremes. Thus, in the past 18 months, the dips created conditions that were ripe for reversals.

Is This Dip-Buying Opportunity Number 8?

The question, of course, is if conditions are currently ripe for yet another jaunt to all-time highs? Or... Will resistance become an issue? Will the rally that started last Thursday fizzle as quickly as it started? Will the buyers finally decide enough is enough? And if the bears can indeed put up a fight here, will any retest of the lows fail this time around?

In terms of the "set up," it does indeed appear that the market is ripe for yet another round of #BTFD. Let's go to the data.

Stocks Were Oversold

First, the S&P 500 had become oversold last week. Take look at the lower clip in the chart above. The stochastic indicator shown is a very simple illustration of overbought/oversold conditions. In short, when the blue line moves below the lower horizontal band, it is an indication of a short-term oversold condition.

In addition, if one looks at the percentage of stocks more than two standard deviations below their 21-day means, it becomes quite clear that stocks had become oversold. In fact, last week's reading on this indicator was at the second highest level of the year.

Another way to look for oversold conditions is to look at the CBOE's Volatility Index - aka the VIX. While the absolute level of the VIX remains low (reflecting the low volatility environment) a spike in the VIX is usually associated with an oversold condition. And as you might suspect, last week the VIX spiked higher.

In looking at the various VIX indicators, note that the 30-day momentum of the volatility index had moved above its "Bollinger band" (set at 1.0 standard deviations above the 50-day mean). On an absolute basis, the 30-day VIX momentum reached the third highest level seen in the last 12 months. And yes, that represents an oversold reading.

Sentiment Had Become Uber-Negative

Finally, investors should note that as of last week, the sentiment indicators had all reached extreme levels - on a short-term basis. The good news is that extreme sentiment readings are an indication that anyone looking to sell stocks had likely already done so.

Remember, sentiment indicators aren't about "dumb money" versus "smart money" as so many pundits content. No, it is important to understand that extreme sentiment readings are an indication of the action investors have already taken.

The key to using sentiment indicators effectively is to first wait for an extreme reading (check). Then it generally pays to look for the readings to reverse. So, if an extreme negative reading is reached and then reverses, this tells investors that the market is likely sold out from the near-term perspective.

What's Next?

So, let's review. We've seen the eighth dip-buying opportunity in the last 18 months, which was accompanied by an oversold condition and extreme readings in sentiment. This presented a solid set-up for a bounce. Friday's upbeat Jobs Report provided a trigger for the bounce to get legs. Now the question is whether or not the move is sustainable.

On that note, it's so far, so good as Friday's move was fairly impressive and the world's equity markets are following Wall Street higher this morning.

However, it is important to note that the recent dip-buying moves have become increasingly weak. For example, during the rally that occurred in Q4 2013, the S&P 500 managed to tack on more than 7 percent to the previous high. Whereas the #BTFD opportunity in February added only 2 percent to the old high. Then then rally that ended in July added about 5 percent while the most recent joyride to the upside only added about 1 percent to the old highs.

The bottom line here is that the market's upside momentum has been suspect of late. Therefore, the easy part of the move - i.e. the dip-buying/short-covering part - may have already taken place. Now, the hard work of attempting to make new highs begins.