It’s a common-sense strategy that makes intuitive sense: if you think a correction or even a bear market is coming, wait it out until stock prices drop, then buy up stocks at a discounted price and watch them rebound. A classic tactic of active investors, waiting for price declines or “buying the dip” can also be justified from a value investing perspective. If a particular security or even the whole market seems overvalued, waiting until it’s more fairly priced would seem to be more prudent.
An active investing strategy that appeals to value investors? Surely any idea that can unite such opposite philosophies must be correct, right? Wrong. At least, sorta. This week I’ll guide you through the do’s and don’t of trying to wait out fair prices, and what it means for preparing for the next correction or recession.
So to start, why is the idea of buying the dip attractive?
For value investors, the most important consideration for deciding to wait for a dip has to do with overvaluation. The most common way to assess the intrinsic value of a security is the earnings per share (EPS), which is simply the amount of profit that a company earns annually, per outstanding share of stock. Dividing the price of the security by EPS gives the price/earnings (P/E) ratio. A typical P/E ratio is around 20, and a higher ratio indicates that the price is high relative to the value, or, in other words, that a stock is overvalued.
The theory of “reversion to the mean” states that, in the longer term, stocks tend to return upward or downward to prices that represent a fairly typical valuation. If a stock has a low P/E ratio, the theory goes, it will eventually return to a higher price and is a good investment, while a stock with a high P/E ratio will eventually come down. By this logic, waiting until overvalued stocks experience a price correction seems reasonable, but there are a few reasons why it might not be:
High valuation is a prediction of future earnings. If a stock has a high P/E ratio, it’s probably an indication that investors believe that a company has a high potential to start making more money in the future. A low P/E is often an indication of pessimism about a company’s ability to stay profitable.
Also, P/E ratios are usually calculated based on earnings from the past year, so one unusual quarter can drastically shift a company’s P/E ratio. If a company experiences one bad quarter, their P/E ratio might shift upward without any change in their fundamental profitability. If they put out a new product after a period of expensive development and suddenly start making a lot of money, their P/E ratio will drop, and everyone who believed in them will start to feel pretty smart.
That’s why it’s important to research a company’s recent earnings and the reasons for their over- or under-valuation before making a judgement on the basis of P/E alone.
Momentum is real. As much as it pains value investors to admit, some price movement is just about past movement. A stock trending up or down is likely to stay that way, for a period of up to several years. In the long term, undervalued companies do better, on average, than overvalued companies, but in the shorter term price momentum is actually a much better predictor of future price changes. An overvalued, uptrending stock might keep you waiting for years before a price drop, and in the meantime a company is likely to grow organically enough that even a reversion to the mean will leave the stock price higher than before.
Sam Lee wrote an article last week specifically about buying the dip, for which he built and backtested a dip-buying algorithm. His algorithm, as it turns out, performed much worse than a benchmark, which he attributes to missing out on upward momentum. Because it waited around on price dips to buy, it missed out on sustained periods of growth.
Momentum, it’s important to note, also applies to asset classes like commodities to which the previous point about profitability doesn’t apply.
But what about timing the market as a whole? The P/E ratio of the entire S&P 500 is often used as an indicator of the amount of excessive capital in the stock market, and hence as a predictor of corrections. The more the market is overvalued, as the logic goes, then the sooner and more drastic a correction is likely to be.
However, comparing the P/E ratio and price of the S&P 500 over time gives shaky evidence for this theory. In 1983, 1987, and 1990, relatively high P/E ratios arguably foreshadowed minor corrections (though they might have simply come down as a direct result of price drops.) In 1991, though, a pretty sharp peak in the S&P’s P/E simply came back down harmlessly. For the two most major downturns, between 2000-2002 and 2007-2009, large spikes in market P/E were clearly symptoms rather than predictors, as companies’ profitability hemorrhaged. In fact, the stock market’s peak in 2000 actually occurred during a time of relatively low market P/E, and and the mid 2007 turnaround was preceded by only a very slight, year-long uptick in market P/E. The most recent short-term corrections, in mid 2015 and early 2016, were not obviously preceded by irregularities in P/E.
To date, the market’s P/E has been slowly and steadily increasing since 2011, so it certainly doesn’t give any clear indication of a coming correction, even as some market analysts are increasingly convinced there will be one. Sam Lee recently wrote another interesting article pointing out that valuation changes across entire asset classes (like stocks) are often long-term shifts in the way the a market functions, and impossible to use as the basis for timing the market.
This is true for many other indicators as well. Economics is a very inexact science, and economists are usually caught by surprise when the market decides to tank. The real takeaway when considering trying to hang back and wait for a correction is to remember the third and most important point:
Time in the market beats timing the market. If you only remember one thing from this article, remember this old investors’ adage. It’s important to keep in mind that, across time, the market goes up. If you pick any random point in time, investing is more likely to be profitable than not, so you should stay in the market as much as possible, and the burden of proof should be on claims that the market is about to go down. Choosing to stay out and time the market is essentially a choice not to invest, which risks missing out on big gains.
That being said, there are some strategies besides spending 100% of the time in the market that can be more profitable. Sam’s algorithm shouldn’t be taken as the only way to buy dips. In my opinion, it was built to spend too much time out of the market. I’m in the midst of working on a dip-buying algorithm that spends a little more time in the market. My current version buys when the current price is below the past week’s average, and sells if the current price is above the past month’s average (defaulting to buying if both are true.) Backtested since 2006, it nearly doubles the gains of the S&P, and only experienced 37% drawdown in the 2008 crash.
We’ll see where that goes.
When it comes to the near future, it’s hard to know exactly what to do. I’m personally shifting some of my portfolio into commodities and investing more in companies with solid value, but I’m certainly not leaving any of my assets in cash. A recession might start next summer or we might have to wait five years for one, but making major portfolio changes on the basis of expecting one is essentially gambling with our savings.
I guess what I’m really trying to say is, keep investing, and keep tuning in!
Until next time,