Buying the dip demystified

If there has been one investment adage during the last 10 years, it has been “buy the dip”. Like the birds chirping at the rising sun, investors tweet “buy the dip” at the first hint of the stock market dropping. The difficulty lies in knowing where and when the bottom of the dip is since none of us can possibly predict the future that accurately.

In an effort to demystify the main topic of this blog, let’s get into the common definition of the buy the dip (BTD) strategy and what it actually means for rational investors. Typically, when you buy the dip, you are investing in a security/or index that has experienced a decline in price, thereby buying it at a bargain cost. You are hoping that the security or the index will rebound and that you will be able to sell it at a higher price. In reality, we cannot predict what the markets will do in the future but rather we can look at previous market data to “back-test” a buy the dip strategy, this is what professional investors would do. It is important to mention that purchasing the dip will not likely be a long-term winner if people end up sitting out of the market for those long periods of time when it rallies. You will keep waiting for the price to fall lower and lower, without knowing when to buy before it is too late.

History was on the side of buying stocks after rapid declines. Let’s take a look at how the buy the dip generation came to be. The fact that dips were often followed by new highs created the most powerful positive feedback loop in the history of the markets. The act of buying weakness has been nicely rewarded again and again. Point in case, S&P 500 had 4 minor dips between March and December 2009 (-5.5%, -9.1%, -5.6%, and -6.5%), all of which quickly recovered to surpass new highs, hence allowing BTD to work.

In early 2010, the large dip of -9.2% was followed by a recovery and then the flash crash hit May 2020 (-17.1%) between April and June 2010 but S&P fully recovered before year-end. Fast forward to the Covid crash in 2020 (-35.4%) that took only 6 months to fully recover and go back to new highs. After that, we saw another dip in September 2020 (-10.6%) which was followed by new highs two months later. In 2021, we saw a minor dip in Feb through March that was again followed by new highs and a steady advance thereafter. However, looking back upon the history, the S&P 500 took seven years to achieve a new high from 2000 to 2007, following a 51% drop from its previous peak between March 2000 and October 2002, and six years to reach a new high from 2008 to 2014, following a 58 percent drop from October 2007 to March 2010.

Buying the dip can be rewarding when you give due attention to the reasons behind the dip. Was the dip because of market fears or because of the company’s performance? While some people will rush to the sidelines during times of heightened volatility and uncertainty, the increased volatility can be used to find good bargains and add on to those companies with valuations that have a significant disconnect to their underlying fundamentals. Investors will have the most success if they are executing an investment plan and have additional cash set aside for opportunistic buy the dip strategies. It is about not buying indiscriminately but rather using these broader pullbacks as an opportunity to upgrade portfolio holding by executing a piecemeal strategy (for example if the investor has $10K in cash, the person can invest $2000 at a time whenever there is a dip as opposed to all of it at once). Always be sure to gauge the quality of the company and always do your research in checking out the balance sheets and the profitability of the companies. We will elaborate on these a little later in the blog. The source of funds is just as important, for example, it would be a poor idea to withdraw money from an emergency fund or a retirement plan to buy stocks during a pull-back.

Fast forward to the present time, the headline-making phrase, buy-the-dip continued to be in favor, and the price action since the onset of the pandemic has generally favored the strategy as every drawdown since the beginning of 2020 has been followed by a comeback, however, since the dismal start for the equities this year, the dip buyers realized that they may have to better buckle their seat belts. First of all, the war aggravated an unpleasant start to 2022 for stock investors amid a background of a capricious Fed gearing up to tighten monetary conditions and raise rates. The stagflation worries compounded when the war erupted at a time when Fed was already falling behind the curve, meanwhile, energy prices exploded in the face of mounting uncertainty, with European leaders discussing shutting off Russian imports, and as sanctions, inflation and the pandemic threaten global growth. All these headwinds made the stock market dips less pronounced. The data suggested that during the first week of the war the retail investors were keen on maintaining the BTD approach, however, their buying collided with sales from institutional investors making the strategy less effective in terms of building a short-term bounce. This has become true also due to thinning of the central bank shield (removal of quantitative easing), which has separated ever-higher asset prices from fundamentals for far too long.

If you intend to buy the dip, I would recommend pursuing an index as opposed to single company stock as the latter could be a riskier proposition, and always stick with good quality companies. When it comes to buying the dip, keep in mind that there is no one-size-fits-all solution. What may seem like a good idea to one person may not be so to another. As a result, it’s critical to weigh all of your options and make the greatest selection possible. I cannot stress enough: do not try to time the markets, instead, there are some widely used metrics to assess the price trends and determine whether there is simply a market dip or the market is heading into correction territory. The first one I will mention is Dollar Cost averaging. Dollar Cost averaging is a strategy to manage price risk where you divide up the amount of money you would like to invest and buy small quantities over time at regular intervals. This helps decrease the risk of fluctuations. Two simple metrics to assess would be 50-day and 200-day moving averages that are typically used on broad indices like S&P500. 50-day moving average, also called 50 DMA, is a technical indicator used by some investors and it is simply the security’s average closing price over the previous 50 days; the number of stocks above or below 50 DMA levels can help investors understand the direction of where the market may be headed. The 200-day moving average, 200 DMA, could be more telling than the 50 DMA and is one of the most followed indicators. When the index moves below 200 days moving average it is considered a bearish signal indicating a likely downward trend and vice versa. A word of caution: the technical analysis will work until they won’t, therefore there has to be a fundamental rationale behind wanting to buy the stocks at the dip, meaning sticking to companies with strong balance sheets and growing earnings power, have proven historical performance and have weathered different market conditions and it could be a chance to buy these stocks at a value when the prices are down. Needless to say, trading acumen, skill, and experience possessed by the Fund Managers will be essential to identifying such opportunities to navigate the rapidly changing markets and acting with agility to accurately recognize a particular pattern of price behavior in a stock/index that will be rewarding for the investors in the end.

Before I end my blog, I leave you with a fun game that uses historical 10-year cycles for the US stock market to illustrate the points highlighted above.

https://www.personalfinanceclub.com/time-the-market-game/