MARKETS SPECTATOR: Prepare for the pullback

Profit takers are beginning to pounce and are likely to be locking in gains for the next day or two. A decent pullback will be an ideal time to buy into this established uptrend.

It’s looking like another positive day for the local equity market as the rally that ignited cyclical names yesterday continues. Having said that, after briefly breaking up through the psychological 4600 level to 17-month highs this morning, we’re seeing some profit-taking come into the market this afternoon.

This isn’t surprising at all, as I wrote yesterday given the market has had a very strong short-term rally. We’re now at a confluence of resistance levels and are starting to see some players lock in the recent gains, hoping they will be able to buy back in at cheaper prices. This is a healthy sign.

It’s been the cyclicals leading the charge yet again, especially iron ore and energy names, as we continue to see signs of rotation out of the recent outperformers like the banks and Telstra, just to name a few.

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Source – Iress

The above hourly chart of the S&P/ASX 200 index shows the short-term pullbacks the market has seen since the recent lows. This is what we would be expecting to happen in the next day or two, although even a slightly deeper correction would be perfectly normal.

While these sorts of pullbacks are easily tradeable for the swift, short term trader my advice to those with medium to longer-term time horizons is to simply ignore them. In fact, when we get a deeper correction I would recommend the ‘buy on dip’ strategy as a great way of entering the market with the least amount of risk and most upside potential.

By buying stocks during pullbacks within an established uptrend, you are naturally avoiding one of the most common mistakes of chasing the market higher.

Is the market worried about the cliff?

If so, it’s certainly not showing it. As I mentioned yesterday, many market watchers are puzzled as to why the market keeps on climbing in the face of such uncertainty. The bulk of the answer is that the market looks forward, generally by between six to 12 months.

Many participants find it enormously difficult to participate in a rally that they simply don’t believe in and can’t understand. Do you follow your gut instinct and stay on the sideline or do you do what the market is telling you?

Right now, the market is sending a pretty powerful message about the fiscal cliff – it doesn’t seem to care!

Below is a chart of the iShares Dow Jones US Aerospace and Defence ETF (ITA). Defence stocks are considered to be the ground zero for the fiscal cliff as funding for defence would be slashed should the economy be allowed to go off the cliff, so to speak.

However, judging by recent price action investors can’t get enough of the ETF as it rallied to all-time highs overnight, drawing us to the conclusion that the market simply isn’t worried about the looming cliff.

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Source – Iress

Below is another great chart from Business Insider illustrating the stock market performance following tax hikes and cuts. And guess what, it concurs with the above chart.

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Source – Business Insider

So even if the economy was allowed to go over the cliff, the above chart tells us that, according to history, S&P 500 stocks perform much better in the year after tax hikes than they do after tax cuts.