Buying at the dip no longer adds up

Buy the dip. Be it stocks, bonds or more complex derivative bets, investors following this Wall Street maxim have reaped robust rewards in recent years.

Such buying has been evident in the shares of large American companies since March 2009, when the Standard & Poor’s 500 stock index touched a low of 666. (It closed last week Wednesday at 2,399.63.)

It also appeared when investors piled into European stocks after Britain’s vote to leave the European Union last summer. And the phenomenon has been amply illustrated by the wagering that the VIX index, a measure of how sharply investors think stocks will shoot up and down, will continue to move lower as it has done in recent weeks.

Yet as stock markets hit record highs and the yields on volatile junk and emerging market bonds plunge, this view that market corrections should be seen as a buying opportunity, as opposed to a warning to be heeded, has begun to worry investors.

The fear is that each subsequent rebound will embolden excessive risk taking and inflate richly valued stock and bond markets. Investors have repeatedly shaken off the risks of political turmoil, including the latest shock, President Donald Trump’s firing of James Comey, the director of the FBI.

The very next day, the S&P 500 ended the day up 0.11 per cent, while the VIX was still near its decade lows, at 10.21. “No one has been penalised for buying the dip,” said Bill Luby, an independent investor and active blogger who specialises in trades connected to the VIX.

Until recently, he has been an active participant in Wall Street’s most popular trade: Betting against VIX futures with the expectation that market volatility will remain quiescent. Now, he is worried about what will happen when the dip becomes something more severe than just a temporary dip, and the index bolts higher as investors panic.

“That trade is really loaded up,” Luby said. “It won’t take much of a spike to cause a lot of pain.” Shorting, or betting against, the VIX is not the only trade of late where investors have been handsomely compensated for setting aside their fears.

Investors have been snapping up government bonds issued by countries like Russia, Turkey and even Mongolia, enticed by mouthwatering yields and a perception that economic and political risks, which previously warned investors away, are no longer so severe.

And in the US stock market, stock pickers continue to ignore sky-high valuations of stocks and the market as a whole, buying up index giants like Amazon, which has a price-to-earnings ratio of 136, Apple and Facebook at the slightest sign of weakness.

Few are predicting an outright market collapse. Economic growth, at home and abroad, is picking up, and the earnings for companies listed on the S&P 500 have been strong. And even with the political upheaval in Washington, most market participants remain convinced that the Trump administration’s pledges for lower taxes and lighter regulation will provide ballast to the market.

And with bank deposits and bonds from developed countries still offering meagre returns, stocks and higher-risk fixed-income securities have come to be seen as the default option for investment managers looking to the long term.

Nevertheless, the combination of complacency and rising markets has prompted a growing number to become more cautious. “We have been in a long up cycle and valuations are above average,” said Bradley J. Vogt, a portfolio manager who invests in large capitalisation US stocks for the Capital Group, the Los Angeles-based fund giant that oversees $1.4 trillion.

“I am holding more cash than I usually hold in my funds right now.”

To be sure, some of this recent spate of buying can be explained as investors looking for bargains in beaten-down areas — like emerging markets. Having lagged the broader rally in recent years, these markets took a further hit in the wake of Trump’s election.

Currencies tumbled and investors took flight, fearful of the administration’s anti-trade policies and a resurgent dollar, not to mention the usual dose of political turmoil. Nishant X. Upadhyay, an emerging market bond investor at HSBC Global Asset Management, took the opportunity late last year to buy Turkish government bonds, betting that worries about President Recep Tayyip Erdogan and his political ambitions were overdone.

It was a winning trade — bond yields have fallen and the lira has strengthened substantially. Now, billions of dollars (Upadhyay estimates over $30 billion last quarter) are flowing into emerging market bonds as investors rush in to get a piece of the action.

“No doubt the spreads are tightening,” he said, in describing how the recent boom in the asset class has made them less attractive relative to lower-yielding bonds in developed markets.

“And there are risks out there. But the question is: Do you want to be sitting in cash right now or investing your dollars in alternative markets?”

Fund managers with a long memory argue that while it may be true that markets are richly priced, it would be a mistake for investors to try to predict when markets will fall and remove their funds accordingly.

Especially now, when cash and safe government bonds are such unattractive alternatives in terms of investment returns. Indeed, for all the ups and downs in the stock market over the last five years, the total return of the S&P 500 stock index is up close to 15 per cent — beating most of the opportunities available to investors.

“The view we frequently hear today is, ‘aren’t stocks expensive now given S&P price to earnings multiple,’ which is at a 15 to 20 per cent premium to the historical average,” said William C. Nygren, who has been investing in US stocks, under the Oakmark Funds brand, at Harris Associates in Chicago for more than 30 years. Making market-timing bets have been a “kiss of death” for investors over the years as stocks continue to rise over the long term, he said.

And that holds true for today, he believes. “We have better economic growth looking forward the next five years than we do looking backward,” Nygren said. “And alternative asset classes offer returns that are exceedingly low.”

– New York Times News Service