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.

Timing is Everything

Last week, the investment team met to discuss whether the events of the past few weeks, namely an important election, an announcement of additional quantitative easing by the Fed, and the recent close of the S&P 500 Index above its April high, means that we should change our investment stance. There has clearly been a change in the leading indexes that are so important in forecasting the economy's direction. Market-based indices like copper, broad-based commodities, and the Baltic Dry Index, as well as the Conference Board, ECRI, and the OECD, have all shown significant improvement. The stock market has reacted positively to the change in Fed policy from discussions about removing stimulus earlier this year, to keeping the current stimulus this summer, to the latest announcement that they are adding $600 billion of new stimulus. Key interest rate spreads that are early warning indicators of systematic market risk seem to be subdued, with the exception of the recent blow-out in PIIGS bond spreads. We are now into the 7th consecutive quarter of above-expected earnings growth where estimates have gone vertical for 2010 and estimates for 2011 are still staying steady at about $95 for the S&P 500. At an S&P price of 1,200 the P/E ratio for the market based on 2011 estimates is only 12.6 times earnings, hardly expensive in a zero interest rate environment.

There is a well-documented bearish case to be made, which we have explored in depth in this blog as well as our quarterly market reviews. The longer-term structural problems with the U.S. economy, and consequently the global economy, are frightening. But the shorter-term questions about the durability of the latest growth cycle remain in doubt as well. There seems to be little doubt that with the Republicans in control of the House of Representatives, investors shouldn’t count on fiscal stimulus to help the market going forward. And now that the Fed has committed to adding $600 billion to their balance sheet, there seems to be little chance of more monetary stimulus in the near future. So the question is where is the organic growth in the economy going to come from? The most popular answer seems to be that growth in the emerging markets will rescue the developed world from a dangerously slow growth scenario. Or perhaps the Fed’s prescription of zero interest rates and quantitative easing will do the trick. I remain a skeptic on both counts.

For now the team agrees that a minimum of benchmark levels of risk are appropriate across all of our investment policies, with the possibility that we could be more aggressive in our DA and DUA policies. The problem is that we are “running a little cool” in terms of risk assets at a time when the market looks very overbought on short-term sentiment measures. In short, investors are too bullish at the moment for us to feel comfortable adding to risk right now. The plan is to buy the dips, if we can get one or two before year-end. The tactics are sound, the plan seems to make sense, and we have high conviction in our assessment of the overbought condition of the market. Now all we need is for the market to cooperate and come back to us. A 5% correction from the recent high takes us right back to the 50-day moving average which is a great place to do a little nibbling. As always, timing is everything.

In Celebration of Market Timing

I am a market timer. I reduce portfolio risk and earn excess returns by selling securities that are overvalued and buying securities with the proceeds that are undervalued. Once I couple the purchase of a security with the sale of the security, I am no longer a buy and hold investor, and I must cheerfully and defiantly define myself as a market timer. In making this statement, I am joining the ranks of the most reviled investors on the planet, all of whom are considered to be uneducated, easily swayed by investment fads and mass media, and most importantly, are doomed to fail in their investment strategy. The reason for certain failure is that, unlike buy and hold investors, the decision to sell based on the valuation of securities is fraught with risk that timers will improperly assess value and sell too early or too late. On the other hand, buy and hold investors live in a mythical world of certainty where security valuation doesn’t matter, and so they ignore valuation in their investment process. This leads to the somewhat ironic state of affairs where proud market timers who are using valuation to minimize portfolio risk are instead considered to be high risk investors, and buy and hold investors who ignore security valuation are considered to be risk averse.

We all realize that the popular perception of market timing is one where portfolios are traded in extremely short investment time frames, and portfolio diversification is considered irrelevant because investors are willing to take the risk of going to an all-cash position when they feel risk positions are unsafe. I happen to believe that this manifestation of market timing is a high risk strategy, but only because I don’t believe that investors should ever be 100% certain in their forecasts, and therefore being 100% in stocks or cash is a little too much risk for my taste. Nevertheless, the idea of being out of the market when it is deemed to be a high risk investment due to poor valuation deserves at least polite applause, regardless of the tactics that are employed.

To be a “market timer” is to join a group of investors that should be celebrating their determination to properly manage portfolio risk. I believe that searching for good values, coupled with portfolio diversification, are the two unbreakable rules of investing and the two tactics that can’t be ignored by investors in properly managing risk in their portfolios. So let’s hear it for the market timers out there. (If I were a musician I would make up a fight song for them.)