The author, for example, once had the genius idea of buying Lehman Brothers shares in September 2008 when the share price had fallen from $US70 to $US2.
The US doesn’t let banks fail, I thought; within days it will be rescued and the share price will bounce right back up again. The Fed decided to let it fail.
I lost my money. I did so because I didn’t buy a dip, I bought a death spiral.
Identifying a dip
So how do you identify a dip? The professional end of town tends to be very wary about the idea of ordinary retail investors trying to invest in this way.
“For most investors ‘buying the dip’ implies timing the market,” says Eleanor Creagh, Saxo Bank’s Australian markets strategist. “And this usually does not add value unless you are an active trader.
“Timing the market is a difficult game, and whilst it might sound great in theory and can be very rewarding if you are correct, usually the odds are stacked against you.”
Aaron Binsted, portfolio manager at Lazard Asset Management, agrees that “as a starting point ‘buying the dip’ is overly simplistic and can be a recipe for unnecessary pain.”
Both Creagh and Binsted have numbers to support their view.
Creagh asks you to imagine that, over the last 30 years, you tried to time the market but were naturally imperfect in doing so: exiting and re-entering the market on average 10 per cent from peaks and troughs.
By doing so, you would end up with half the returns of investors who just stayed invested the whole time, and that’s before you factor in transaction costs.
“If you can time the market perfectly and resist the cycle of fear and greed by selling at the absolute highs and buying at the lows, you can certainly achieve superior returns,” she says.
“But history tells us that usually the most severe market drops are followed by equally violent market rallies.”
Running the numbers
She has a host of statistics to illustrate this: almost all of the best single trading days in the last 40 years have come in association with bear markets or during a steep correction, the biggest two coming in single days in October 2008 just after my half-witted decision to invest in Lehman.
“Arbitraging investor psychology accurately requires you to time to a T not just one event but two – both the top and the bottom,” she says.
“You could time the top perfectly but the probability of getting both decisions correct is low and then subsequently missing out on just a few days of market gains can significantly reduce the value of your investments over the long term.”
Binsted also looks to the global financial crisis for examples of the difficulty of buying the dips. “From the height of the boom before the global financial crisis, if you were buying every time the price fell 10 per cent, you would have had a lot of pain,” he says. “Because the market halved.”
By contrast, 2011 – the so-called taper tantrum around Federal Reserve policy – provided good opportunities to buy the dip. But there’s no clear metric to distinguish between the two scenarios.
Still, this is not to say that investors should just stay in the market endlessly without making any active decisions. Professional fund managers look for good times to buy all the time, so there must be some rationale for being in and out.
“What do we think is sensible? Paying attention to the valuation,” says Binsted. “Buying the dip is all about the trend. Valuation is about the level of the market.”
Returning to the GFC and the taper tantrum, he says, investors would have made better decisions had they considered valuations.
Before the GFC, the Australian market was trading on a forward price-earnings ratio of 16 times, well above historical averages. “From that overvalued starting point, buying the dip was crazy.”
But in 2011, the one year forward price-earnings ratio was 10 times. By now an investor would be buying slower earnings on lower multiples. “And the returns for the next number of years were fine. Valuation has to be the starting point.”
So, in these volatile times, where are markets today? The threat of a US-China trade war, uncertainty around Brexit, an unpredictable US president, a slowing China: these things have made for an uncertain outlook for both Australian and world stock markets.
“Expensive but not scary”
“We would say that, in aggregate, the market is slightly on the expensive side of fair value,” says Binsted. That means that, all things being equal, you would expect equity market returns to be below their long-term average. “But the market is by no means as overvalued as it was. Things look a little expensive but not scary.”
It is important to look deeper than just the numbers for the overall market, because each sector is under different stresses and subject to different opportunities. You might, for example, be inclined to buy Australian bank shares, which have been badly hit over the last year of the royal commission, and the reputational issues that preceded it.
Jun Bei Liu, a portfolio manager at Tribeca Investment Partners, argues that just because valuations have come down in banking doesn’t mean it’s a good time to buy.
“When I look at the entire industry, I am very wary,” she says. “There are going to be tighter lending standards, earnings are going to grow more slowly and the increase in transparency and accountability simply means the costs are going to get higher as better systems are put in place.
“Earnings are already very tough for those businesses and it’s hard to see that improving any time soon.”
Binsted agrees, arguing that levels of consumer gearing and house prices gathering negative momentum could make buying the banks “a short sighted strategy”. He would also be wary of building materials and consumer discretionary stocks.
Hunting for value
But he does see value. He likes Alumina for its good balance sheet, and “it has assets right at the bottom of the cost curve making a large amount of cashflow,” with the company committed to returns to shareholders. Woodside Petroleum is also well-placed, he says.
“It has very high operating margins, a good balance sheet, a large amount of growth projects it is going to commission over the next few years, and cash flow growth. That is very attractive.”
The commodities cycle is an area where buying the dip is a little more realistic. Commodity cycles move in long, broad sweeps, although they tend to be different according to the commodity in question.
You will never identify the bottom of a commodity market to the day, but there are times at which you can safely say, on a long-term view, that they will go up again before too long, whether that’s copper, iron ore, gold or an agricultural commodity.
Working out whether an individual resource-sector stock is a good investment, though, is more complex. One has to consider what commodities it is exposed to, where it stands in terms of its assets, its balance sheet and levels of debt, and, of course, its share price valuation.
Macro conditions are relevant too. Julia Lee, equities analyst at Bell Direct, argues that timing the market was easier when the overall macro trend was positive.
“The market in general has been rising over time,” she says. “And buying the dip is much easier when you are seeing accelerating global growth. Now there is slowing global growth, it’s a bit more risky.”
But even then, an upward-pointing economy is no guarantee of a soaring stock market, a point that has been consistently demonstrated by China. There are numerous examples of years when the economy has grown 6 per cent or so and the market has actually dropped.
“China’s cycle is very different from the US, which has had accelerating growth for seven years,” says Lee. “China has been in a slowing growth scenario for a while now.”
The verdict, then, is that buying the dip is a difficult trick to carry off, but that you can arm yourself to make the right long-term choices by looking closely at valuation.