By Louis H-P on September 14, 2020Reading Time: 3 minutes
To buy the dip in today’s stock market will have made you money. Not so long ago the stock market was driven by earnings upgrades. Today it is driven by the Fed upgrading its quantitative easing to take in newer asset classes. How has this happened and what should investors pay attention to?
What is buy the dip
Use it to your advantage
Be aware of how it can go wrong
When the response to the 2008 financial crisis found that lowering interest rates to zero was not enough to minimise the impact of the recession, the New York Federal Reserve turned to quantative easing to create growth.
This was supposed to be a short to medium term solution to “stabilise the ship”. Sadly the world and the Fed got used to this form of easy money and this is the now the defunct option when growth slows/fails.
As a result asset prices have become out of kilter with reality. With the fear of missing out being a powerful side effect of a market rally, In turn investors buy the dip whenever a correction occurs creating further momentum trading.
For the purists out there, the continuing rise of stock markets when the backdrop is a Covid-19 caused recession is unnerving. The everything-is-going-up rally means that even overvalued stocks are rising. Although one is right to be cautious, there may be a train ride worth riding for a while.
“If you can’t beat them, join them”
Dollar cost averaging can be used in conjunction with a buy the dip mentality. Every time you have a dip, buying it means that over a period of time you will gain an average entry price for your investments. This is useful as few can predict when it is the right time to buy.
Fundamentally, an investor is looking over the long term for a return. Therefore buying the dip on regular occurrences in strong, stable and potentially undervalued stocks, will increase the value of your stock portfolio.
Few investors like to see their investments go down, but they should! Occasionally the stock market gets ahead of itself (earnings) and a quick, often violent, sell off happens. Usually this is over a 3 day period.
This should be welcomed both as the market is pricing in reality, but also a chance for you to buy in at a more reasonable price. Remember, just because everyone else is losing their heads, does not mean you should too.
The risk with buying the dip is the next fall is the ‘big one’. Any correction could be investors taking profits or worse with systematic risk creating a major sell off. Knowing which is which is impossible even for the most seasoned investors, therefore investing with a margin of safety is wise.
This can be achieved by investing only a small amount of your portfolio. If the market is crashing, you can sit tight knowing you have used a small amount of capital. If it is a smaller mid-sized sell off, you can increase your position, creating a better average entry price.
Today’s investors have got used to the new norm of the New York Federal reserve propping up markets. This has created a culture where ‘bad news is good news’ because it brings more quantative easing from the Fed. At some point the punch bowl will be removed from the party and buy the dip will no longer be the strategy of the day.
Every investor should learn to be flexible. The current market is being driven by a buy the dip mentality. Although individual stock earnings upgrades are still important, the entire market is constantly being given a helping hand by the largess of the New York Fed. Therefore any sell off should be see as an opportunity to top up on companies whose earnings are still growing.