When Does Dip Buying Become Knife Catching?

Buying the dip has become one of the most popular strategies with a wide range of investors, and generally quite a reliable one.  We saw it in action yesterday, when the S&P 500 (SPX) recouped about two-thirds of Friday’s declines.  So far this month, however, we have seen a pattern of lower highs and lower lows.  That is the definition of a downtrend, short as it is.  Here is the concern: buying a dip works really well in an uptrend but becomes treacherous if a downtrend becomes more sustained.

In the chart below, note the activity since the end-of-month spike that occurred at the end of August.  There have been tradeable rallies, but the prevailing short-term trend is lower.

SPX 2-Weeks, 15-Minute Candles

Source: Interactive Brokers

If buying dips works in an uptrend, the opposite must be true in a downtrend.  Selling rallies becomes the preferred strategy.  The direction of the trend dictates which type of trade – long or short – is more likely to be profitable over a longer period.  In theory, that change is easy enough to identify.  In reality, it is extraordinarily difficult to recognize turning points.  Every change in a secular trend starts as a modest change in the shorter-term trends.  Sometimes that trend change is triggered by a major market event, say a day when advances outpace declines (or vice versa) by 10:1 on high volume; but other times the change is subtle. 

A subtle change in trend can be like the proverbial frog in a pot.  The water can seem pleasant, but if the temperature is raised gradually, the frog might not react in time to escape the boiling water. 

Now consider active investors who have been accustomed to seeing every dip as a buying opportunity.  The dips can be bought – even bear markets have (sometimes ferocious) rallies – but the window for profitable trades from the long side shrinks dramatically.  Those who expend their capital chasing downticks risks piling on losses.

That said, so much of this depends upon the trader or investor’s time horizon.  Trends can play out over simultaneously.  For example, in the chart below, we can see that while a shorter-term moving average (10 days) is pointing sharply lower, the longer-term 50-day moving average is flattish, while the 200-day is still pointing solidly higher. 

SPX 6-Months, Daily Candles with 10-day (yellow), 50-day (blue), 200-day (purple) Moving Averages

Source: Interactive Brokers

Thanks to the fractal nature of price movements, even shorter-term trends might be up or down over any given time period even within the longer trends.  The key is matching the trend to the user’s time horizon.  If one is day trading, for example, the longer-term trend may certainly be informative, but the decisions should be based on shorter intervals.  If one is a long-term investor, however, short-term moves might simply be noise amidst a secular move.

The problems arise when people forget that logic, when normally disciplined traders hold onto long positions under the guise of them becoming good investments, or when stolid investors react to short-term dislocations.  Knowing your style and risk tolerance is key.  There’s an old adage that says “bulls make money, bears make money, pigs get slaughtered.”  I know of none regarding frogs getting cooked.

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