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Opinion Credit
This is not the time to run to the feeding trough simply because the bell has rung
by Duncan Sankey
Duncan Sankey
Portfolio director and head of credit research
Cheyne Capital
Buying the dip has been successful recently — but that doesn’t mean we should do it again
To mix (and torture) metaphors, if a market falls, is it a knife not to be caught or a dip to be bought? Recent history would suggest that we have become structurally conditioned to do the latter. That’s not necessarily a bad thing, as long as, in doing so, we assimilate new information into our pricing and probabilistic assessment of the opportunity (a more Bayesian approach), rather than act deterministically (like Pavlov’s dogs at the sound of the bell). The latter runs the risk of momentum-driven overvaluations, crowded trades and market-dislocating risk-offs.
Encouraging investment during a sell-off
At one level, the shift towards passive and programmatic funds has encouraged investment on weakness. Lifecycle funds, which have to maintain a predetermined split between asset classes, will be forced to rebalance by buying into a market that sells off. Quant strategies based on mean reversion will also buy weakness, while flows from savings vehicles such as 401(k)s and ISAs, are similarly programmatic and do not necessarily contract when market conditions deteriorate. (If regulators broaden the investment universe for 401(k)s, this will apply to a wider range of asset classes.)
Stock buybacks, which have been running at a USD 0.8-1tn annual clip in the US, also bolster the dip-buying trend. Management teams will attempt to buy back their company’s stock when valuations are depressed (even if, in practice, their market timing is not quite so adroit). Hedge funds, too, may seek to allocate when values have declined.
The sheer volume of liquidity is another factor. The market is awash with cash-like assets (with rates and valuations relatively elevated, cash becomes a viable instrument). Funds in US money markets stand at over USD 8tn, up 73% from pre-COVID levels. Even a small reallocation in a falling market represents a significant buffer against further decline. Allocations to index ETFs, which must buy underlying assets in proportion to index weights, add to the buying momentum.
Psychological and cognitive factors further prime dip-buying. An extended period of monetary accommodation during the years of austerity has engendered received wisdom that the Fed always has the market’s back. During COVID, the extension of primary and secondary market corporate credit facilities, which provided a combined USD 750bn capacity to buy IG paper, constituted a central bank put. Accompanying the monetary provision was also an extraordinary extension of fiscal largesse. This has fostered a recency bias, where longer-term history is underweighted relative to favourable near-term events.
However, with energy prices rekindling inflation and fiscal deficits ballooning, is it still safe to rely on that assumption? Bear in mind that with an average age of 35, many Robinhood customers were high school juniors during the 2008 recession and have no memory of the dotcom bubble.
Social media platforms and institutional flows also promote herd behaviour, which is self-reinforcing. As the stock markets climb to new highs (the S&P 500 at 7,259 at the time of writing), fear of missing out is a siren call, which can lure investors onto dangerous reefs.
Don’t rely on a programmatic approach
So, with buying the dip, the danger lies in ignoring the context. We probably should not rely on a programmatic approach, but rather should make a decision conditioned by our assessment of prevailing conditions.
This would favour active selection on two levels. First, on the decision of whether to invest on a correction or sit it out. Second, on which asset classes, instruments and factors are best suited to take advantage of current conditions according to our assessment. This is not the time to run to the feeding trough simply because the bell has rung. The dog chow may not be there this time.
