Should we buy the dip?

Last Wednesday we saw a broad sell off in global equity markets. We had not seen this degree of a sell off for quite some time. For instance, the most widely used ETF (QQQ US) of the NASDAQ 100 Composite Index fell 2.54%. The next day QQQ rose by 0.87%, and on Friday it rose again by 0.42% – closing at a level that was just 0.87% away from recent highs.

Our foremost mission is to safeguard our clients’ capital. Therefore, when faced with drawdowns of a significant amplitude, we must decide whether fight or flight is the most appropriate response. In other words, should we be selling, or should we buy the dip?

In this particular case, we have investigated the historical price movements of the NASDAQ 100 because it better represents our current heavy overweight in technology stocks.

Over the past five years, there have been 1257 trading sessions. The average daily move of QQQ was 0.07%. There were 554 down days and 703 up days. On the average down day, QQQ was down 0.69%, while on the up days it rose by an average of 0.67%. What is immediately evident is that QQQ’s movement was larger on the down days than it was on up days. Moreover, QQQ’s positive performance was attributable to a greater number of up days than down days.

In order to define the dips, we have looked at the distribution of returns. Moves that were two standard deviations from the mean started at approximately -2%. Over the period analyzed, there were 32 days when QQQ declined by more than 2% in a single trading session. On average, during these 32 days, QQQ fell by 2.71%. The next day, on average, QQQ fell a further 0.17%. It is important to remember that these are averages. In one instance, after a 3.13% drop, the next day QQQ rose by 2.82%. In another instance, after 4.37% drop in one day it fell a further 3.85% the next day. Therefore, if you were looking to earn on a bounce-back the following day, the past five years of trading history indicate that you would have ended up disappointed.

Ok, but what about the next five days? By doing some more calculations, it turns out that after a more than 2% daily drop in QQQ, two days later you would have averaged a -0.02% return. After three days, returns become positive at +0.34%. Four days later returns averaged +0.52% and increase to +0.6% after five days. Of course, these results spanned a wide range and these are just averages. For example, five day returns ranged from -5.71% to +5.51%. However, we can conclude that on average, investors would have realized a +0.6% return by buying QQQ after a more than a 2% drop and holding it for 5 days.

What about a month later? Taking out non-trading days, we will assume that ‘a month later’ implies the return after the next 22 trading sessions. On average, buying right after the dip and holding QQQ for the next 22 trading sessions would have returned +2.55%. Here the returns also vary quite considerably: from -7.17% in one instance, to a +14.03% return on the positive end.

What are the conclusions? Over the past five years, there has been no point to try to game the market by buying it right after the dip. The next day’s return on average was negative, as was the average return of the next two days. On the third day, average returns became positive, and a month later such a strategy would have returned an average of 2.55%.

As you can see from QQQ’s price graph for the last five years, buying dips would have resulted in higher returns:

For those with a long investment horizon, buying and holding, or adding to QQQ on dips would have been beneficial.

How does this relate to our asset management strategy?

Our overweight in technology stocks has been an important driver in our investment returns. There have been occasions when we have bought on dips, but is important to remember that this only possible if you have capital available. As such, we are very critical of our holdings, and do not hesitate to sell if we believe that a stock has risen too much too soon.

Most of our clients have long-term investment horizons, but that does not mean that we ignore short-term market movements. Our main goal is to never be forced to do anything, but rather to be selling when everyone else feels they have to buy, and buying when everyone else is forced to sell. Taking profits on short-term moves plays a large role in positioning our portfolios to take advantage of cheaper prices during the next sell-off.

It just so happens that last Tuesday we were making sales. By Friday, we had already put some of the proceeds to work…

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