"Why do birds sing so gay
And lovers await the break of day?
Why do they fall in love?
Why does the rain fall from up above?
Why do fools fall in love?
Why do they fall in love?
Love is a losing game
Love can be a shame I
Know of a fool, you see
For that fool is me!
Tell me why, tell me why?"
--Frankie Lyman and The Teenagers, "Why Do Fools Fall In Love?"
There is possibly nothing as inexplicable to many investors/traders and as frustrating to the shorts community (if it still exists) as the continued buying of stocks on nearly every dip. This buy-the-dip activity helps to explain the lengthy absence of market drawdowns over the last several years and the virtual nonexistence of any dip that holds.
Tell Me Why
Today's opening missive aims to answer these three questions:
* What is influencing the buy-the-dip action?
* What could change the buy-the-dip behavior?
* Will the buy-the-dip action continue?
My responses will be brief and not all-encompassing, and while some of the answers to the questions are surely more complicated, I plan to keep it simple as I try to think logically in a market that is illogical to many.
Basically I am trying myself and trying to get everyone else to think in advance about this important buy-the-dip issue and to be anticipatory in your investment process by considering the contrary.
What Is Influencing the Buy-the-Dip Action?
- Interest rates are extraordinarily low and the financial system is awash with liquidity served up by the central bankers. The Fed is moving so slowly that investors don't believe they need to be worried. Outside of the U.S., Japan and China are not tightening. That massive liquidity must go somewhere, and every dip is purchased thanks to the monetary largesse of the world's central bankers.
- Machines and algorithms, which are the engine to ever-more dominant quant strategies, are programmed to buy dips because that activity is proving to be profitable.
- The growing popularity of passive investing -- seen in the proliferation of assets under management in exchange-traded funds (ETFs), which now outnumber the amount of stocks -- perpetuate dip buying. As markets turn back up from losses earlier in the day or just continue to rise, ETFs rebalance late in the day and buy, further extending the bullish trend. Moreover, most retail investors now own ETFs rather than individual stocks and it has been documented that many actually believe ETFs have little risk, so they lack fear of market declines.
- Over the last decade about 17% of the shares outstanding of publicly held companies have been retired through share repurchase programs.
- About 45% of the companies that have been listed on exchanges have disappeared through mergers, leveraged buyouts, failures and so forth. Both Nos. 4 and 5 have changed the demand/supply imbalance in favor of further market gains.
- Though many disagree, the buy-the-dip mentality to me is partly based on the hopes of big tax cuts, both corporate and individual. This has likely provided a "put" to the market.
- All the above have contributed to the price momentum, and because many traders and investors worship at the altar of price momentum the trend tends to perpetuate itself.
What Could Change the Buy-the-Dip Behavior?
- Monetary policy may become more restrictive. In the U.S. this already is happening as the Fed is anticipating more rate hikes in the coming 15 months (at least three) and will initiate quantitative tightening (QT) in October (though this is less so outside of the U.S.).
- A change in primary market price trend could change the relationship between dip buying and quant strategies. If buying the dip becomes unprofitable and stops working, the algorithms likely will change and no longer will be programmed as they are today.
- Exchange-traded funds lose their popularity. This could occur if the market begins to change lower and the primary price trend changes from up to down, if certain ETFs fail to track their underlying stocks constituency (producing an ETF "flash crash"), and if, for any reason, money begins to flow out of ETFs.
- If confidence in a growing and stable domestic economy diminishes. It is my view that the probability of a U.S. recession occurring anytime in the next two years is about 40%, but is growing as housing and autos likely have peaked for the cycle.
- Any number of currently unexpected Black Swans or policy errors, fiscal and/or monetary. Ergo, something unknown and not currently expected that no one sees coming. (Think, for example, how the assassination of Archduke Franz Ferdinand, out of the blue, caused World War I or how the Thai debt crisis caused the 1997 Asian financial meltdown.)
- An Orange Swan emanates from the Robert Mueller investigation or from any other source. Consider what would happen if, as I suggested in my 15 Surprises for 2017, Donald Trump becomes a part-time president and nothing gets done administratively and confidence in the system puts a pall over the markets.
- The possibility that most of the administration's pro-growth fiscal initiatives are substantially diluted and delayed.
- If interest rates rise to a level that competes with stocks. This might occur if the opposite of No. 6 happens -- that there is a fiscal deal announced (tax reductions and a infrastructure spend) that hastens the increase in rates.
- Valuations move to an extreme and are simply unsustainable and weigh down stocks, which begin to sell off on "good" news.
Will the Buy-the-Dip Action Continue?
- That is the $64,000 question.
- I hope not!
- Above all, remember my pal Tony "Dwyerama" Dwyer's great quote, "Corrections seem only natural, normal and healthy until they actually happen."
(This commentary originally appeared on Real Money Pro at 9:03 a.m. ET on Sept. 21. Click here to learn about this dynamic market information service for active traders.)