Thinking Probabilities, Not Predictions.

Experts on financial TV and people on X and other social media platforms are talking about buying the dips. The rationale is that the stock market always goes back up and we have strong companies with their stock prices selling at big discounts.

In these situations, it is important to distinguish between the general and the specific. No one will dispute that in general the stock market goes up. If you look at the S&P 500, it is set up in a way that it goes up. Because it is a group of the best 500 companies in the US. Poorly performing companies are removed periodically and replaced with companies with strong performance.

But do we know if the stock market will go up tomorrow or next week or next month?

Whether companies are selling at big discounts or not is a more subjective discussion. What is factual is that most companies have lower prices than a few weeks ago.

But how do we know they were not priced at a premium them? And how do we know they are priced perfectly now? What if they are indeed selling at a discount, but if we wait more, we may get them at even bigger discounts?

These are the specific questions that I think of when people generalize to say that companies and selling at a discount and the stock market always goes up. Basically, I am asking about timing - when to buy again, and valuations - what is the right price for a stock.

Fundamental investors track the earnings growth and price multiple of individual stocks over a long period in time. This information is easily available through various stock market platforms. So, it is easy to track that ABC has had an average growth rate of x% per year and an average price multiple of y. So, a simple approach would be to say that the earnings remaining the same (x%) if the price multiple is lower than y then the stock price is selling at a discount.

This is true from a mathematical perspective. But it still does not answer when someone should buy that stock. Because we do not know whether the stock price will be discounted further or will revert back immediately to its average. In a perfect world (known also as efficient market hypothesis) price of a stock should always remain at its long-term average. And when there is any anomaly in either direction of the average, it should revert back to the average instantaneously.

However, we know that is not exactly what happens. That is why the research around this perfect world was called a hypothesis (the efficient market hypotheses). There is a simple reason for this. And this lies in the specific questions I asked earlier in this note. No one really knows the answers to the questions. Several people (experts and otherwise) will make predictions and some of them will be right. But it is unlikely that those same people will be able to repeat the success of their predictions the next time or several times or always.

Where am I going with all this? Where I am going is that we have to replace the term “predictions” which is what people are making, to call them “probabilities”. When we start to try and answer the questions from probabilistic perspective rather than a predictive perspective, we will be able to deal with these uncertainties.

And we can only take a probabilistic approach using technical analysis. Every conclusion we make using technical analysis will NOT turn out to be right. That is the definition of a probabilistic approach. We are saying what are the chances of something happening - we are not guaranteeing it.

Let us discuss the “buy the dip” discussion.

The question in front of us is when is it the right time to buy the dip?

If we review the SPX daily chart, we may say it looks like a good time to buy now.

The above SPX chart is daily candles over 1 year. I also have the RSI plotted below with default settings. We can see that the RSI level is at 36 which is still not saying by conventional measures that we are oversold. The standard measure on the RSI is to use 3o as oversold and 70 as overbought levels. So, going by that standard measure, we may conclude that we should wait and not buy this dip yet as price can go lower (can get more oversold than now).

But then we can see that we never went oversold using the conventional measures in the whole year. We came close to the 30 level in Apr 2024 and Aug 2024 and then price started going back up from there. So, we can conclude that the RSI does not need to go down to or below 30 for price to start rising higher.

Having said that, we can also see that over the last week or so, the RSI has bobbled up and down several times between the range of 32 and 44. That means we have had a few false indicators of reversals or buy signals. So, the RSI itself may not be able to tell us whether we should buy this dip. It is not conclusive.

The picture below is the same chart with the 50-day SMA (purple) and the 200-day SMA (yellow) added to the chart.

We can see that the price is congregating or creating a “knot” at the 200-day SMA currently. Clearly the 200-day SMA is an important level and price is respecting that.

So, we could place a trade for a bounce using the combination signals from the RSI and the 200-day SMA. However, this could end up being a very short-term trade since we do not a convincing indicator from the RSI. So, we would have to monitor or place a stop loss if the trade goes against us.

Looking at the 50-day SMA, we can see that price is well below that as of now. We could decide to wait for the price to cross over the 50-day SMA to be more confident that we indeed have a reversal at least for the short-term. That would be a more prudent trade and have a greater probability of success.

I highlighted the question “when is it the right time to buy the dip?”. In truth, the real question is when is it the right time to buy based on what time horizon?

Why do I say that? Let’s review the same SPX but now on a monthly chart instead of daily. So, each candle represents a month instead of 1 day.

The above is 20 years of SPX and I again have the RSI with standard settings plotted below the chart. We can see now that the RSI is completely in the opposite direction from what we saw in the daily chart. Here, the RSI is showing overbought conditions and, in fact, a reversal after reaching those oversold levels.

This is why I said earlier that, if we take a long trade right now, it may be a short-term trade. Because we were looking at a shorter duration and timeframe chart. Looking at a longer-term chart places the situation is a different perspective.

I have marked the RSI area with 4 markers indicating the last times that the rice reached overbought conditions on the monthly chart. We can see that on all of these occasions, price remained overbought for several months. Also, only on 1 of the 4 occasions did price go down all the way to being oversold after being overbought.

So, from a longer-term perspective, we may remain overbought for a long time and, even when price falls, it may be temporary. So, while this is informative and provides us perspective, it may not alter our shorter-term trading plan.

I used the RSI and the moving averages to go over defining probabilities. I also use support and resistance levels that I draw on charts myself as I see these patterns emerge. I also use the MACD and the Chaikin Money Flow (CMF) indicators.

This was a different type of weekend note to discuss how I view the stock markets. I did use the SPX although I did not talk much of trending today. The trending remains bearish, and we are close to oversold levels. Also, remember that a bounce may not necessarily mean the bottom is in as I wrote last week.

Have a great week ahead.