Buy The Dip – Legitimate Strategy or Just a Meme?

August 26, 2021

Buy the Dip? A closer look at the meme.

By. J. Burckett-St. Laurent

Sr. Portfolio Manager, EWA

Social media has exploded with trading strategies and money-making ideas since 2020, fueled by stimulus checks and work-from-home in conjunction with the rise of Robinhood and zero-commission trading. One of the ideas that has grown increasingly popular is “buy the dip.” This concept dates back at least as far as the recovery from the 2008 Global Financial Crisis (“GFC”). An early (and obscene) animated meme captured the Zeitgeist of the time perfectly: “what do you not understand, just buy the bleeping dip!” In essence, the idea is to take advantage of declines in equity markets (or Bitcoin, or any other risky asset) to add exposure, potentially profiting from a rebound. This simple idea is enticing, and because the S&P 500 and other assets have indeed bounced back rapidly from declines in the last decade (aided in part by the U.S. Federal Reserve’s repeated and ever-more aggressive interventions) it seems superficially sound. The reality is that as with most investment strategies, the devil is in the details.

Question number one that dip buyers must answer is, “what’s a dip?” Is a 1% decline from the trailing 1-year high a dip? What about a 5% decline from a 1-month high? Perhaps a dip occurs when a 50-day moving-average is breached? Any of these might work, or none of them. What are the odds of timing the purchase well enough to bottom fish successfully, as opposed to misfiring and buying too soon, followed by a bigger decline? When using margin, this could be catastrophic. A more complex framework is required than “buy the dip.” Suddenly, the “easy money” idea from the meme seems like real work.

The second question we must answer is, “with what cash?” You can’t buy unless you have cash, or are willing to use margin, or sell something else. Those trading on margin can easily add exposure to risky assets as they decline. However, at some point all investors hit the cap on their risk allowance, so there also needs to be a plan to reduce the exposure back to baseline. When do you sell? Investors holding a balanced portfolio containing some portion of lower-volatility / lower-risk assets might rebalance from the low-risk asset into the risky asset on a dip, and then back to the baseline allocation. Again, the process requires a framework to identify not only the dip, but also an exit strategy. Again, the complexity escalates. Many investors receive periodic inflows of cash from employment, so another valid strategy would be to hold back or “hoard” this cash rather than invest it immediately upon receipt, hoping to put cash to work in the event of a dip.

I am employed and have new cash to invest periodically. As a result, this final plan is of interest to me personally, and I back-tested it to see if it would work. The “buy the dip with new cash” strategy requires the least amount of work, since only an entry strategy is required, not a plan to time both the entry AND exit. We are just adding to a buy-and-hold position, so the exit would come only in retirement, death, or a change in strategic asset allocation. Should be easy to make money buying the dip, right? The meme said so.

I assumed that a hypothetical investor would receive $1,000 of new cash every 10th trading day, roughly twice a month. I assumed that this cash would be “hoarded” (invested in short-term treasury bills) until a dip occurred and would then be fully invested in the SPY ETF (tracking the S&P 500). All prior contributions would be kept fully invested in the S&P 500 and never sold. The time period used for this back-test was 12/29/95 through 8/23/21. I’d consider this to be a reasonable time window, as it contains at least two full market cycles. In a perfect world, I’d use hundreds of years of data across global financial markets, but there’s an argument to be made that markets evolve over time. Perhaps dip buying works now in the QE-infinity/ZIRP/stimulus era, when it didn’t in the past? Whatever the case, I wanted to keep this simple, so I tested only the SPY/BIL combo and only for this time period. If I wanted to work for my returns, I wouldn’t be trying to invest on the basis of memes!

I tested dips of 1, 3, 5 and 10% versus the trailing 22 trading day (approximately 1 month), 66d (~1 quarter) and 256d (~1yr) high, as well as relative to the 50-trading-day and 100-day simple moving averages. I compared this in total returns (including dividends but without commissions, fees, bid-offer spread, taxes etc.) to a strategy that invested the cash immediately upon receipt. Results are in the table below. I found little to no benefit in waiting for a dip rather than investing immediately, especially if you consider the potential impact of those commissions, fees, taxes and bid-offer spreads that we ignored. The bigger the dip we wanted, the more time we spent in treasury bills and the lower the total returns.

Interestingly, this approach worked worse than usual in 2021, despite the quick rebounds from every decline. The reason is simple: on average the dips weren’t big enough to take the price below where it was when I could have bought previously. The market’s strong performance doomed the dip buyers. Financial assets tend to exhibit a fairly well-known effect known as momentum. Prices that have been rising, tend to keep rising and vice-versa. In contrast buy-the-dip is what’s known as a “mean-reversion” approach, betting that the short-term pattern will reverse. Either can work as the basis for a trading strategy, but simplistic rules using percentage drops from various levels or simple moving averages tend to favor momentum. Historically, if you sold the S&P 500 whenever its price dropped below the 200-day simple moving average, went to treasuries, and rotated back into equities after the price had begun to rise back above the 200 sma, you’d have performed marginally better on a risk-adjusted basis (again ignoring commissions, fees, taxes etc). This approach increases trading frequency and adds costs, but it’s a valid way to raise your risk-adjusted return by attempting to cut off the left tail of the very worst outcomes, at the cost of lower total return in most time periods. It worked very well in certain bear markets (2008-10 GFC) and poorly in others (Feb-Mar 2020) depending on the duration of the decline and the speed of the rebound. This signal moves slowly, so in 2020 it delivered the worst-case outcome, exiting the market near the bottom and reentering quite late.

Overall, my conclusion after looking at the data was that buy-the-dip is just a meme and nothing more. I will not be stockpiling new cash to buy the dip. While this meme is entertaining and perfectly captures the frustration of many professional investment managers, some of whom feel that the market “should have had” several sharp falls in the last decade were it not for government intervention in financial markets, the meme lacks the rigor required of a realistic investment approach.

The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity. The U.S. government partially funds itself by issuing 10-year Treasury notes.

The SPDR S&P 500 Trust ETF, also known as the SPY ETF, is one of the most popular funds that aims to track the Standard & Poor’s 500 Index, which comprises 500 large- and mid-cap U.S. stocks. These stocks are selected by a committee based on market size, liquidity, and industry. The S&P 500 serves as one of the main benchmarks of the U.S. equity market and indicates the financial health and stability of the economy.

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