3 Reasons to Buy the Dip
Twenty-five years ago, the stock market suffered one of its worst losses of all time…
Culminating on “Black Monday” in mid-October, more than $1 trillion in wealth disappeared during the crash of 1987. So it’s only fitting that stocks are once again starting to stumble during this not-so-happy anniversary.
The financial media have jumped all over this curious coincidence. Playing on skittish investors’ emotions, they’re trying their best to connect the recent pullback in stocks to the dramatic events that unfolded more than two decades ago. But as much as the storytellers want to spread their fears of a market top, most are conveniently leaving out some important information about the 1987 crash and its aftermath.
How different are 1987 and 2012? For starters, the market was red-hot back in ’87. Stocks are doing just fine right now — but 2012’s year-to-date performance is nothing compared with the first three quarters of 1987, when the S&P was up 39% at its highest point, according to Bespoke Investment Group. In comparison, the S&P has peaked at gains of 16.6% so far this year.
Bespoke also notes more favorable valuations this time around: “In 1987, the S&P 500′s P/E ratio at the low after the crash (14.37) was still higher than it is now (14.28).”
Also, it’s important to note that the 1987 crash turned out to be one of the best buying opportunities ever. The short-lived crash was the last major downside event equities would experience until the dot-com bubble began to burst in 2000.
Had an investor waded into the market in the aftermath of the 1987 crash, five years later, he would have seen a portfolio annual gain of 14.5%, compared to the average five-year gain between 1926 and 1987 of 9.7%. Ten years later, his portfolio would have gained 17.2% per year, compared to an average 10-year gain of 9.9% between 1926 and 1987.
You can see that even after a violent correction, investors encountered plenty of opportunities. Still, stocks are sinking quickly this month. Now that short-term market momentum is waning, should you run for cover? Not yet, in my opinion…
Instead of panicking, here are three reasons to look for buying opportunities during this autumn pullback:
1. Stocks have not broken major support
Despite its recent losing streak, the S&P 500 has yet to set off any alarms. Yes, stocks have violated the uptrend that began with the market bottoming in June. But as of this morning, they have not broken below key support levels:
Last week, the S&P topped out at about 1,460 for the third time since September. Now, with the uptrending channel broken, we should look for support around 1,400. I doubt the market will give us a picture-perfect bounce right at 1,400 — so you might want to consider giving stocks some leeway to about 1,385.Turning to our momentum gauge (bottom), you can see how overbought stocks were in early September — and how quickly the market was able to relieve the pressure from these extreme conditions.Bottom line: There’s nothing wrong with some sideways action in October to set up two historically strong trading months — November and December.
2. Small names are perking up
I’ve been highlighting the underperformance in small-cap stocks for several weeks now. If you’ve been paying attention, you know that the Russell 2000 — my preferred small-cap index — has not been able to match the performance of the market at large.However, throughout recent market weakness, smaller stocks are catching a bid…Over the past five trading days, the Russell 2000 has lost only about 2.5% — while the S&P 500 and the Nasdaq booked losses of 2.8% and 3.25%, respectively. This divergence was even more apparent during Tuesday’s trading session, with the Russell losing only 0.5%. In contrast, the S&P shed more than 1.4% yesterday. The Dow lost 1.8%.
If riskier assets like small caps can continue to attract money — even as the markets sink — I feel a lot better about a potential bounce sooner, rather than later.
3. Market chasers should help prop up stocks
Stock fund underperformance could help sustain the market’s winning ways into the fourth quarter.Hedge funds continue to lag their benchmarks this year — marking nearly four years of subpar performance. That’s the longest period of underperformance since 1995-98, according to The Wall Street Journal.According to Hedge Fund Research, hedge funds gained an average of only 4.7% through September. That’s way below the S&P’s 14% gains.Fund managers are dying to get in on the action — yet they’ve been on the wrong side of the market so far. If they collectively use market dips to buy into stocks gracefully, it’s possible that we could see a much healthier market in a matter of weeks.
Despite all of this evidence in favor of equities, it’s important to remember that the market can and will do anything. I don’t think you should go “all in” on stocks just because we’ve seen a sharp pullback. Always wait for the market to give you the proper signals before making a move. In this case, you should be looking for a meaningful bounce at support to confirm that stocks could be leveling off — and possibly headed higher in the near term.
Greg Guenthner, CMT
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