Will buying the dip pay off? Here’s what history shows

“Buy the dip” has been a headline-making phrase lately. Whether from professional strategists, or in the form of a meme on Twitter, the mantra has inspired an entire generation of investors to go bargain hunting for stocks in the face of a market pullback.

Moreover, price action since the onset of the pandemic has generally favored that strategy: every drawdown since the beginning of 2020 has been followed by a comeback to a new high.

But after a dismal start to the year for equities, and amid a backdrop of a capricious Federal Reserve gearing up to tighten monetary conditions and raise interest rates, dip-buyers anticipating consistent rebounds to all-time highs may have to temper their expectations — at least in the short term.

The S&P 500 posted a negative return of 5.26% for January 2022 – marking its worst month since the benchmark plunged 12.5% in March 2020 after COVID-19 upended the global economy.

LPL Financial chief market strategist Ryan Detrick points out that poor January performance has historically been followed by weakness in February. Data collected by LPL going back to 1960 showed that after drops of 5% or more in the S&P 500, February performance has been lower six of the past seven times, with muted returns over the final 11 months of the year. To add to that, February has been one of the worst months of the year for the index since 1950, with only September being worse.

“We are encouraged by the big reversal in stocks last week and we think stocks are in the process of forming a meaningful bottom,” Detrick said in a note. “But the truth is, this year is going to be much more volatile than last year and investors had better buckle up their seat belts if the first month is any indication.”

Dip buying has proven to be a winning strategy even before the pandemic market boom. In an analysis of the S&P 500 over the past 12 years, Compound Advisors’ Charlie Bilello found that since 2009, whether experiencing loops of minor dips and quick recoveries, or large downturns followed by vertical comebacks, the index has always forged ahead to new highs.

However, a further look back shows this has not always been the case. The S&P 500 took seven years to reach a new high from 2000 to 2007 after a 51% decline between March 2000 and October 2002 from its previous record, and six years to notch a fresh high from 2008 to 2014 after a 58% loss between October 2007 and March 2010.

“While it’s always hard to predict the bottom of any market sell-off, we believe the risk-reward for U.S. stocks is getting attractive,” UBS equity strategist David Lefkowitz wrote in a recent note, also indicating the sell-off in past weeks felt uncomfortable because investors have become accustomed to a period of limited drawdowns over the past 15 months.

UBS also added that investors selling off on the prospect of Fed tightening may be a bit “too cautious,” pointing out that stocks have risen by an average of 5% in the three months before the Fed’s first rate hike since 1983, despite an initial ramp up in volatility once the hiking cycle begins.

‘A good entry point for longer-term investors’

Hodges Funds portfolio manager Eric Marshall told Yahoo Finance that investors should use the dip as a buying opportunity, but rather than indiscriminately buying the market, use the broader pullback as an opportunity to upgrade portfolio holdings.

“This is a time to use a rifle, not a shotgun,” Marshall said. “While some investors rush to the sidelines during a period of volatility and uncertainty, our investing approach during this type of sell-off has always been to use periods of increased volatility to find bargains and add to those stocks with valuations that have a significant disconnect to their underlying fundamentals.”

Anxiety over what the Fed will do wreaked havoc on markets in January. The S&P 500 tiptoed into correction territory last week (though clawing back to end up 0.08%) after remarks from Fed Chair Jerome Powell following the central bank’s two-day policy-setting meeting strongly signaled a liftoff on interest rates to above their current near-zero levels was likely to come in March. But some on Wall Street have called the market’s reaction overblown.

“The equity market sell-off is overdone in our view, and we reiterate our call to buy the dip, particularly in cyclicals and small caps,” said JPMorgan strategist Marko Kolanovic in a new research note.

Other institutions on the Street have echoed similar sentiments.

“To the extent that zero interest rate policies, negative real interest rates and quantitative easing have been supportive for risk assets, it is understandable that a perceived move away from these supports should cause a correction, particularly given high valuations,” Goldman Sachs strategist Peter Oppenheimer wrote in a recent note. “But this adjustment has now been reflected in the markets and the downside risks from here are much lower so long as economies can grow.”

Oppenheimer added that “we are getting closer to levels that have typically been a good entry point for longer-term investors.”

Villere & Co. portfolio manager Lamar Villere told Yahoo Finance: “While we expect to see continued volatility in 2022, it seems as though every time a member of the Fed Board of Governors speaks at a luncheon, the market jolts and provides new opportunities.”

Alexandra Semenova is a reporter for Yahoo Finance. Follow her on Twitter @alexandraandnyc

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