Buy on the dip – Proceed with caution

As promised, I am alerting my readers to a buy signal in CRB’s stock market momentum indicator (SMMI). This is an indicator I have found useful for taking short-term positions in the market. Since 1994, the buy signals have been active for an average of 98 days, with a minimum of 52 days and maximum of 191 days. The average annualized return has been just over 45% with a minimum of 4.6% and a maximum of 161.4%.

There are a few reasons I am wary of the stock market in the medium term (2 years or so). First, the credit market problems that have surfaced this year are hardly over and while volatility has spiked sharply, the S&P 500 is still only 6.1% off its July 19 peak – hardly a catastrophic move. Further rounds of bad news concerning credit markets, which could come at an unexpected moment, would likely send the market down sharply again.

Another damper on my optimism is that the extended streak of double-digit corporate profit growth has been fueled by rising profit margins, which have now reached extreme levels. Unless we have entered a new era where labor is willing to concede a larger share of GDP to owners of capital, profit margins are likely to come back down.

However, it is worth noting that 2001 and 2002, very poor years in the market, each had two surges of 14% or more. It would be unreasonable to expect to catch all of the positive returns without taking some of the negative, but the SMMI caught a part of three of those moves, each time yielding positive results.

Taking all of this into account, I will heed the system and increase my position in the market in the near term. For instance, I consider this a good time to cash in on some S&P 500 put options I purchased during the summer.