Don't Buy The Stock-Market Dip This Time
"Buy the Dip Becomes Buy the Correction as S&P 500 Bounces at 11%," a Bloomberg Business article on August 25th cried out. Indeed, since March of 2009, "buying the dip" has been the proper investment action. As recently as September and October of 2014, the S&P 500 lost 160 points or 8% over a twenty-four day period before rebounding and hitting a new, all-time high on May 22, 2015. Buying the dip worked as fear came and quickly went: concerns about the spread of Ebola, slowing European growth, and a Federal Reserve supposedly set to raise short-term interest rates could not stem the rise in U.S. equities for more than a few weeks.
Given the recent success of the "buy the dip" approach, similar advice prevails today. However, caution is warranted. There is a stark contrast between today's investment climate and the risk-tolerant environment of the past six years.
Since stocks began their upward climb from the depths of the "great recession" in March of 2009, there have been just four corrections of 10% or greater, including the current one. Prior to the August selloff, it was all the way back in 2012 when the S&P 500 last lost 10%. The pundits held weak economic and jobs data responsible. Before that, the S&P 500 lost 16% between May and October of 2011. At that time, the European debt crisis dominated the headlines. Finally, in 2010, there was a 15% correction between April and July. Weak economic data and the first "flash crash" on May 6, 2010 received the blame. Every time, "buy the dip" worked.
With that backdrop, investors might be compelled to shake off their present fear and use this late summer swoon to increase their equity exposure. Yet, the conditions today look quite a bit different than they did even nine months ago. Sure, fundamental arguments that equity markets are overvalued were just as strong in late 2014 as they are today. Assertions that central bank interventions will eventually prove destabilizing have been compelling since at least 2010. Further, the economic drag from excessive global debt-to-GDP levels has played out in real-time over the last six years. Everyone knows the recovery has been weak. In fact, fundamentals have looked poor for quite some time. The difference today is that market internals are sending a consistent signal that investors are becoming more and more risk averse.
In a recent New York Times piece, "Rising Anxiety That Stocks Are Overpriced," Yale professor Robert Shiller takes readers through the evolution of investor psychology leading to a significant market correction:
As time goes on, the stories justifying investor optimism become increasingly shopworn and criticized, and people find themselves doubting them more and more. Even though people are asking themselves if prices are too high, they are slow to take action to sell. When prices make a sudden drop, as they did in recent days, people tend to become fearful, even if there is a subsequent rebound. With the drop they suddenly realize that their views might be shared by other people, and start looking for information that might confirm their belief. Some are driven to sell immediately. Others are slower, but they are all similarly motivated. The result is an irregular but large stock market decline over a year or more.
How can we tell when investor psychology is changing and the end of a bull market is near? Credit spreads are a simple, yet still incredibly powerful, tool for evaluating investor risk preference. The spread between Baa and Aaa corporate credit indicates the difference between the borrowing cost for the best and worst investment grade companies. When investors become more risk averse, they charge the lower quality companies more to borrow and credit spreads widen. The opposite happens when investors become more risk tolerant - investors charge Baa borrowers less and spreads narrow. Today, the Baa/Aaa spread stands 64 basis points (bps) wider than it was one year ago, and at 121bps, the widest spreads have been since they began widening last year. Credit spreads are telling us that investors have become significantly more risk averse.
Contrast this with the other instances of 10%+ equity market corrections during the current bull market run. In April of 2010, credit spreads were 206bps narrower than the year before. Credit spreads told a similar story in May of 2011 when they stood 13bps narrower than the prior year. Though equities sold off at each point, the less-reactive credit markets signaled to investors that they did not need to worry.
Like credit spreads, equity market internals can offer insight into investor risk tolerance. There are probably too many "market internal" statistics to count, but what they all do is demonstrate how pervasive or divergent market action is. If a rising market is consistently validated across different market subsets (e.g. a preponderance of individual stocks, sectors, and capitalization groupings within a market all moving up with the market index), this indicates investors are generally risk tolerant. If different market subsets consistently validate a declining market, this indicates investors are generally risk averse. Divergence between market subsets (some validating, some disagreeing with the broad market) signals a potential shift in investor risk tolerance.
Combining the information from credit spreads and market internals helps investors get a clearer picture during ambiguous periods. Credit spreads provided a false warning in 2012. Prior to the April-June equity correction, credit spreads widened by 35bps from the prior year. While not flashing red, this did signal modest caution. Importantly, a review of market internals failed to corroborate the signal from credit spreads. In early April 2012, 70% of S&P 500 stocks were above their 200-day moving average (dma). In addition, the New York Stock Exchange advance/decline line for all securities had confirmed the most recent S&P 500 high. In other words, the average individual security was in a bull market, supporting the broad market index.
Today, both credit spreads and market internals signal investors are consistently and increasingly risk averse. On August 17th, when the current sell-off began, credit spreads were 50bps wider than one year ago. Only 41% of S&P 500 stocks were above their 200dma. The NYSE advance/decline line failed to confirm the July all-time high of the S&P 500. While the index hit a new high, fewer and fewer stocks participated in the rally. Then, during the August broad market downturn, market internals were consistently negative. Credit spreads continued to widen. These signals are uniformly indicating caution.
It is rare for bear markets to play out over just days or weeks. And, they are typically filled with significant bounces. It would not be inconsistent with the historical record if the S&P 500 retested its all-time high. Nevertheless, absent a narrowing of credit spreads or a shift in market internals, investors should avoid "buying the dip" and perhaps become more defensive.
