“BUY the dip” is such a simple expression of bull-market psychology that it has its own internet acronym, with added obscenity for emphasis: BTFD. The dip on Wednesday was bigger than usual, but for the BTFD’ers that should mean a bigger opportunity to buy. Should you join them and pick up stocks?
Mostly this depends on investor psychology. If others are going to buy the dip, so should you. But we can be a bit more granular about it. Potential buyers can be split into three main camps: Those who want to buy growing companies, and care less about the price, those who want to buy cheap stocks, and care less about growth, and those who just want to buy stocks with rising prices, or momentum.
The market has been driven up this year by the growth investors and the momentum investors, both buying the disruptive tech stocks. Performance of the best has been amazing; in one example, shares of video-streaming site Netflix at the start of this month were almost double where they started the year.On Wednesday both groups abandoned the market. Suddenly, for the first time in ages, valuations of the companies they like mattered. In the technology, health-care, communication-services and consumer sectors the highest value stocks tumbled the most, with a strong inverse link between valuation and performance.
One interpretation is that buyers focused on fundamental value didn’t want to pick up the overpriced growth and momentum stocks, so their valuations had to fall further.
For an example, consider Netflix. Its shares tumbled 8% on Wednesday, their worst performance in more than two years. That took its valuation to less than 80 times estimated 12-month-forward earnings for the first time in three years, and 32 times book value. Even after such a big fall, bargain hunters aren’t going to see anything they like.
That means Netflix has to attract buyers from the other two groups, growth and momentum. Growth investors might be happy to step in at a lower price, because their focus is on long-run expansion prospects, which were unchanged. The difference between 80 and August’s 100 times 12-month-forward earnings is all but irrelevant when what you care about is revenue in three or five years’ time.
But momentum investors are going to be hard to tempt back, because the momentum has broken. Sometimes there are investors who missed the rally who want to take advantage of a fall to join in—a classic example of blindly buying dips. But they need to be converts to the basic story behind the growth, and the combination of rising bond yields, a soggy global economy and political uncertainty may well deter them.
There’s another interpretation. Perhaps highly valued stocks did so badly purely because of rising Treasury yields. If you expect fat profits far in the future it justifies a high price-to-earnings multiple, but higher yields mean those future profits are worth less when discounted back into today’s money. Call this the efficient market view: Bond yields went up, so the price of high-growth stocks went down. Duh, right?
Well, not quite. If markets were efficient, these highly valued stocks would have been falling for months as yields rose. Worse, bond yields actually fell slightly on both Tuesday and Wednesday, so if prices fell because of last week’s yield rise they did it in their own sweet time. A break in momentum is a much better explanation for Wednesday’s move, combined with the fact that markets are complex. The more prices fell the more they fell, until suddenly everyone rushed to get out.
Investors who think that other investors still believe in growth stocks at (almost) any price, or who think that momentum will soon resume, should be buying the dip in the likes of Netflix and Amazon.com. Otherwise, you can find both safety and a return above inflation from short-dated Treasurys for the first time in years, or join the hunt for bargains among the value stocks and hope momentum stays broken.