Monday, November 22, 2010

Dip Buying 101

Pinnacle Advisory Group is presently engaged in an investment practice known as “buying the dip.” Dip buying implies that you have a bullish stance towards whatever security that you are purchasing, and that you are using a short-term price decline to enter the position at more favorable prices. Dip buyers sometimes affect a somewhat self-important attitude in that buying dips implies a value conscious approach to investing, which is usually regarded as highly rational and professional. After all, only overly emotional “retail” investors purchase securities when they are making new highs, allowing the herd to stampede them into buying right at the top. It is the cool, calculated, value investors who have the steely nerve to let the market “come back to them” before purchasing. Any purchase price that is lower than the latest price high represents a victory for dip buyers, who steadfastly and with great conviction refuse to look too far in the rear view mirror for fear that they will find out that even though they bought a dip, they actually acquired the shares at a far higher price then they could have if they had simply joined the crowd and bought as the shares were breaking out to new highs.

Dip buyers live in fear of bloody fingers caused by trying to catch falling knives. This expression refers to the trend follower’s creed that falling prices beget more falling prices, and so buying into a falling market is like “trying to catch a falling knife.” When dip buyers pull the trigger and buy they are hoping that they are not buying into a sustained bear market where they are doubling down on positions that are fated to continue to lose money. While dip buyers are proudly and expertly buying as prices fall, in the privacy of their office they are stockpiling Band-Aids for bloody fingers and planning for their exit strategy if things don’t go as planned. Even worse, dip buyers often have a target price that the security must reach before they execute their purchases. As the market begins to fall you can feel the anxiety of the dip buyers begin to rise as they get nearer to their price targets. It’s like rooting for a horse in a close race. “Come on Rose Bud!” How horrible it is to see a security price turn around and begin to rise again just before it hits your price target.

Momentum investors think dip buyers have lost their marbles. They wonder why in the world anyone would try to buy a falling market just when the market is establishing a trend to the downside. Sheer lunacy they would say, and in some cases they are right. In this particular case our assessment is that the weight of the evidence suggests that we won’t have a double dip recession. If we are right then buying a dip is an excellent strategy for adding to risk assets without waiting for a trend to develop or reverse. At the moment we are fine tuning our asset allocation and making minor mid-course adjustments in portfolio construction. The past week or so has seen the broad markets sell-off almost exactly as we expected. Perhaps we will get to our price target in the next few days and complete our transaction (we chickened out and added 1% even though we were still a little short of our target). Rest assured, if the market trades down and through its 50-day moving average we will complete our planned transactions, but the entire investment team will make certain that our box of Band-Aids isn’t too far away.