Trading in a ‘dip and run’ stock market

US stocks rallied in February after selling off in January and the S&P 500 Index (SPX) closed the month at multi-year high. A surprise? Yes and no. Yes because market breadth had been weakening for months and the US equities were due for a significant pullback. I wrote about that in the February report.

On the other hand, a well known pattern played out. Let’s call it the “dip and run market”: stocks sell off a couple of percentage points. After a second leg down, the market starts to rally strongly without looking back.

Usually, one would expect at least a minor consolidation after the initial thrust up, but this just doesn’t happen. Stocks keep running up for weeks and frustrate every bull who is not fully invested.

Traders, who are looking for a pullback to increase exposure keep looking forever and finally have to start chasing the move. Thus, creating even more buying pressure.

February price action has been a perfect example of this pattern: since hitting a short term low on February 3, the S&P 500 recorded only two down-days (days with lower intraday high and low).

The same structure appeared multiple times in 2013 during May, July and October. In order to outperform in this environment, one has to be extremely nimble and aggressively buy into the dip.

The later approach has one issue: one day, the dip & run pattern will stop to work and a larger consolidation will materialize. Until then, I’ll try to monitor market internals closely and quickly close short positions when stocks start showing strength again.

Another important market characteristic to always monitor is sector leadership. During a bull market, strength can rotate from one industry to another to keep the rally going. Exactly this process seems to be going on since the beginning of the year: Consumer Discretionary stocks had been outperforming the broader market for years, but showed weakness up until the last week of February. However, the sector recovered well in the last days and March will tell if investors are moving out of Consumer Discretionaries into other sectors.

Technology and basic materials have clearly been on the winning side since December last year. In fact, the Select Sector SPDR Technology ETF (XLK) made it into our newly launched Active Momentum portfolio in February. In my opinion, the Active Momentum is an efficient ETF-based implementation to capture relative and absolute strength effects.

Talking about Active Momentum: the best performer in the portfolio so far has been the iShares Nasdaq Biotech ETF (IBB). Despite its run in the last months, I continue to be long this sector.

However, I sold a portion in February because daily price moves have been getting more volatile, a sign that IBB is rather at the end than at the beginning of its move. Fundamentally, Biotechs are expensive, which prompted Goldman Sachs to downgrade the sector in January.

In summary, the bull market in US stocks seems intact. If breadth can catch up, the market should have more room to run.

DISCLAIMER:  The investments discussed are held in client accounts as of February 28, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.  Past performance is no guarantee of future results.