When Should You Buy the Stock Market Dip?
It's official – the stock market reached correction territory. The S&P 500 dropped more than 10% from an early January high to a low in late February amid concerns over the Ukraine conflict, inflation and rising interest rates. Over the long run, we know that the market increases in value, but in the short term there is volatility.
That volatility is a double-edged sword. Downturns like the current one may tempt investors to "buy the dip," or take advantage of lower prices to increase long-term return potential. But if you buy too early in a downturn, you run the risk of riding prices much lower.
So when is it acceptable to buy the dip?
It is difficult to determine whether a small dip will turn into a 10% correction or a correction will turn into a bear market, typically defined as a 20% decline.
But there are certain metrics and strategies to use in these inevitable market scenarios to figure out when is the best time to buy in.
If you've never experienced a market correction or haven't bought the dip before and are looking for new ways to manage your investments in this environment, here's what you need to know about buying stocks on the dip or in a correction:
- Metrics that identify a market dip or correction.
- Buy-the-dip strategies: Cash, dollar-cost averaging, hedging.
- Understanding stock fundamentals.
Metrics That Identify a Market Dip or Correction
When determining whether there is simply a market dip or whether the market is headed into correction territory, you can review two basic and widely used metrics to assess price trends. The 50-day and 200-day moving averages are effective indicators used on broad-based indexes like the S&P 500.
The 50-day moving average is the first line of support or resistance to a market uptrend or downtrend. The number of stocks above or below their 50-day moving average can help investors understand the direction of where the market may be headed in either a dip, correction or bear market.
The 200-day moving average is the average closing price of an asset for the last 200 days. Since there is more data associated with this metric, it can be more telling than the 50-day moving average. For example, if the price of an asset goes below the 200-day average line, it could be the case that stocks in the index have further to fall, potentially in correction territory.
"Historically, when indexes violate that 200-day moving average or 50-day moving average, it can lead to greater declines in the market," says Christian Magoon, CEO of Amplify ETFs.
On the other hand, price movement that goes to the lower end of that range or stops before it hits the 200-day or 50-day moving average could suggest that there could be a mere market dip, Magoon says.
Buy-the-Dip Strategies: Cash, Dollar-Cost Averaging, Hedging
Dips and corrections can happen quickly, so investors who have market strategies ready can respond to a potential buying opportunity. When buying shares of stock in a dip, implementing certain strategies can help investors manage their market risks as well.
Many investors tend to be fully invested at all times, but it can be a smart strategy to have some cash on hand in case of buying opportunities.
"Cash could be the liquidity you need to take advantage of a short-term buying opportunity or a dip in the market," Magoon says.
You can quickly access cash on hand to buy the dip, and even on the way down, he says, cash can act as downside protection
Dollar-cost averaging is another useful strategy to take advantage of market dips. Dollar-cost averaging is accumulating assets in your portfolio over time on a regular basis.
This strategy reduces the risk of price fluctuations over time.
If there is a dip in the market, that may be a time to adjust the parameters of dollar-cost averaging, Magoon says. Instead of a traditional 70%/30% equities/bonds allocation, for instance, you can switch to 90% equities when that asset class is priced at a discount, he explains.
Another buy-the-dip strategy Magoon recommends is hedging across asset classes. This means that some of your money is in stocks and some of your money is in another asset class, like bonds, to balance out the risk exposure. This is essentially pairing your "risk on" assets with "risk off" assets.
Another way to approach this strategy would be buying higher-quality or blue-chip equities. These are companies that have the best balance sheets, have proven historical performance and have weathered different market conditions. Shares in these companies are typically long-term plays. If their share prices are down, it could be a chance for you to get the stock at a value.
As you're thinking about these strategies, investors may want to consider rebalancing their portfolio.
As equities appreciate, it's important to rebalance, which means moving money between equities and other asset classes. Doing this allows you to keep allocation balanced and actually puts you in a better position to buy a dip.
If you haven't rebalanced, it's hard to buy into dips because the majority of your assets could already be in a dip, Magoon says.
Understanding Stock Fundamentals
You don't necessarily want to buy stocks just because their prices are down. There has to be rationale behind your decision. This is where fundamental analysis comes in to evaluate a stock to make sure you are buying it at the right time and for the right reasons.
When you understand the fundamentals of each individual security, there can be buying opportunities when a stock is down.
Thomas Hayes, chairman and managing member of Great Hill Capital, says investors want to ask themselves when valuing a company, "What is a stock trading at relative to its historical range?"
Investors can start with a simple valuation metric called the price-earnings ratio, or P/E ratio, to understand how much they are paying for earnings.
For example, if a stock you're interested in has traded between 10 and 15 times earnings for the past 10 years and now it's trading at 9 times and earnings are growing, maybe there's opportunity to pick some up at a discount.
Look at the company’s balance sheet from the past few quarterly earnings statements.
Does the company have a risk of being over-leveraged?
In a recessionary environment in which a company could have trouble raising capital, investors should determine whether it has a heightened risk of defaulting. "You don't want a company that may be in a position that when they have to borrow money, they can't borrow money," Hayes says.
In a similar light, another component Hayes recommends that investors review is earnings power, which assesses a company's long-term profit potential based on current fundamentals.
Are earnings growing or contracting?
This is a way to evaluate a company's overall financial health.
Understanding the context of the market can help investors navigate stocks in a buy-the-dip range or market correction.
Hayes describes the current market environment for context: "The earnings power for 2022 for the S&P 500 is expected to grow 8.5%," he says.
Buying the dip can seem like a difficult strategy because investors have to determine when they want to go into the market, similar to timing the market when it goes down. The way to approach this is by adopting research strategies and portfolio management tactics to set yourself up for the right buying opportunities.
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