foxex: Buy the Dip in 2019?

Chart Advisor | INVESTOPEDIA

Focus on the Price

By John Jagerson, CFA, CMT

Tuesday, January 1, 2019

1. Buy the dip?

2. Market breadth overextended to the downside

3. Margin debt may rally

Major Moves

The longest bull market in history came to an end in 2018. So what does 2019 have in store?

If it's anything like the end of 2018, it's bound to be riddled with volatility. The same concerns and unknowns that hovered over Wall Street during December are still alive and well in January, and traders are still waiting to see what news the upcoming earnings season will bring.

One thing we do know for sure is the market will have to build from the ground up if it's going to stage a comeback.

Market Breadth

One of the difficulties of using an index, like the S&P 500, as a proxy for what is happening in the market is the index can be misleading.

Depending on how the index is calculated, a small number of stocks can drive a large portion of the index's movement, masking what is happening to the other stocks that have less of an impact on the index's valuation.

For example, because the S&P 500 is a market-cap weighted index, the companies with the largest market cap exert the greatest influence on the index's value. Currently, the 10 largest companies in the S&P 500 are responsible for more than 20% of the index's movement. Looking at the three largest, Apple (AAPL) is responsible for 3.9%, Microsoft (MSFT) is responsible for 3.3% and Amazon (AMZN) is responsible for 2.9%.

Naturally, it is important to watch these stocks, but what about the rest?

Looking at a market breadth indicator, like the "S&P 500 Stocks Above their 200-day Moving Average," can provide insight into what is happening with the other components in the index.

In early-2018, more than 80% of the stocks in the S&P 500 were trading above their respective 200-day moving averages.

By the end of the year, that number had dropped to measly 15%.

The interesting thing about this decline is it wasn't matched step-for-step by the value of the S&P 500 itself.

While the S&P 500 Stocks Above their 200-day Moving Average indicator had climbed during the summer of 2018 to arrive at a lower high in September than it had reached in late-January, the S&P 500 index had climbed to a higher high – reaching its all-time high of 2,940.91 on September 21.

This divergence between the breadth indicator and the index itself indicated that the larger companies in the index were driving most of the bullish growth.

Typically, divergences like this can't last, and this one was no exception. By the end of the year, the S&P 500 had dropped back down to be in line with the woeful breadth indicator.

Some traders may look at this as a negative sign, but contrarian analysts are chomping at the bit to see if this out sized decline will show that the bears have finally run out of steam.

The decline at the end of 2018 may have laid the groundwork for a bounce in 2019.

Margin Debt

If the market is to have any hope of staging a comeback this year, it is going to need buyers with access to lots of cash.

Buyers provide the demand in Wall Street's supply-and-demand equation, and buyers can demand more when they borrow some of the money they use to buy stocks.

According to Regulation T of the Federal Reserve Board, traders can borrow up to 50% of the purchase price of a stock. That means if a stock costs $100, you can use $50 of your own money and then borrow another $50 to purchase the stock.

Borrowing money to buy stocks is referred to as buying on margin, and the amount of money you have borrowed to buy stock is called "margin debt."

By tracking the total amount of margin debt being used to buy stocks in the market, we can get a good sense of not only how much demand there is on Wall Street but also how confident traders are.

Confident traders tend to borrow more because they believe they are going to see a strong return on their investment. Nervous traders tend to borrow less because they are worried they could exacerbate their losses.

Margin debt was steadily rising during most of the latest bull market, but it did experience three sustained pullbacks: one in late-2011 to early-2012, one in late-2015 to early-2016 and one in late-2018.

Source: FINRA.org

These pullbacks coincided with pullbacks on the S&P 500 because in order for a trader to pay back the money she has borrowed, she must first sell the stock she purchased with the funds.

Margin debt has already pulled back from an all-time high of $668,940,000,000 in May 2018 to the latest reported number of $592,593,000,000 in November 2018. The question is, how much farther will it drop?

If margin debt can rebound, the S&P 500 will likely rebound too. If margin debt continues to contract, the S&P 500 will likely continue to fall.

Bottom line: 2019 may be a "buy the dip" opportunity

With stocks coming into 2019 battered and trading below their 200-day moving averages and traders coming into 2019 with reduced margin debt levels, the market has an excellent opportunity to rally out of the dip – if you can call a confirmed bear market a "dip."

It is going to take a lot of confidence building and a strong Q4 2018 earnings season, but the S&P 500 has plenty of room to rise.