The stock market has gone from “overbought” to “oversold” and back to “overbought” – all in about a week.

What can we say? The “Buy the Dip” crowd did it again.

As the stock market started to sell off last week, and many folks thought we were finally going to see the long-awaited and highly anticipated correction, the dip buyers stepped up at just the right time.

And, as we’ve seen numerous times over the past year, the market formed a “V-shaped” recovery and bounced to new all-time highs.

This isn’t normal…

Prior to this past year, a V-shaped recovery in stocks was about as rare as a four-leaf clover. But, as we pointed out last month, traders have become conditioned to buy any dip – no matter how mild.

“Stocks only go up,” they cheer. And, they jump in with buy orders on any 1% or 2% pullback.

Who can blame them? The strategy has worked quite well so far this year.

But, like most popular strategies, there will come a time when it stops working.

Folks will step up to buy the dip, and instead of seeing an immediate V-shaped bounce, stocks will keep falling… And then we’ll get a more significant correction.

When will that happen? I have no idea.

But, the market does provide clues to let us know when the risk of a correction is rising. One of those clues is the value of the Volatility Index (VIX) option prices.

We’ve often written about the predictive power of VIX options. In fact, just before last week’s 90-point decline in the S&P 500, we warned that the market’s “crystal ball” had turned bearish.

By last Thursday, however, after the market had fallen and the VIX had spiked higher, VIX call and put options were trading for about the same premiums. That was a good clue that the downside was limited, and the market was preparing to bounce off of oversold conditions.

Now though, the “crystal ball” is flashing bearish again. VIX call options expiring next Wednesday are trading for about five times the price of the equivalent put options. That’s also true of the VIX calls expiring in mid-September.

Traders are willing to pay five times more to bet on a higher VIX than on a lower one. And, a higher VIX usually goes along with a falling market.

Add to this the negative divergence on the index charts, the short-term overbought conditions caused by the recent bounce, and the extremely bullish sentiment of the dip buyers (a contrary indicator)… I suspect the next decline may be the one where the “buy the dip” strategy doesn’t pay off so well.

Best regards and good trading,

Jeff Clark

Reader Mailbag

Have you been part of the crowd that’s buying the dip? If so, are you prepared to change your strategy soon?

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