Buying on Stock-Market Dips Is Logical

One Step Backward, Three Steps Forward Tuesday's Wall Street Journal published a nifty little chart, courtesy of LPL Financial, that showed the U.S. stock market's improving powers of recovery. For 70 years, a one-day market decline of at least 2% elicited no visible reaction: On average, the market reacted to the drop by matching its long-term norms for the next one-week, two-week, and one-month periods. Buying after a steep one-day loss was neither a help nor a harm.

That has changed since the bull market started in 2009, in a big way. Since then, a one-day market dip has been followed by an average one-week gain of 1.3%. For one month, the profit is just more than 3%. Annualized, those figures amount to 45% for the one-month period, and double that (90%) for the one-week measure.

Blaming (or Crediting) the Fed The article states, "much of this [behavior] is due to conditioning from the Federal Reserve." (It's unclear whether this is the writer's view, that of the LPL researcher, or both.) Stocks tend to plummet because of worries about either economic weakness or rising interest rates. Since 2009, when that has occurred the Federal Reserve has cooed soothingly, thereby lowering the expectation of an interest-rate hike and thus boosting the stock market.

All true. That said, connecting effect with cause is a perilous exercise. People can answer for their motives, markets cannot.

Many other explanations for the strong recent recoveries are possible, including the simplest of all: The findings are noise. Those 2009-16 results are averages, not medians. That means that a handful of very large gains might dominate the results, making it appear as if buying on dips routinely succeeded, when in fact the tactic generally did not.

Even if buying on dips worked consistently, the 2009-16 time period contains just 67 observations. That is a small sample size. Yes, it's sufficient to calculate statistical significance, as determined by conventional measurements. But it's not big enough to give much comfort. Consider the matter this way: A 5.5-year-old mutual fund that has thrashed its benchmark since inception has 66 monthly observations. How much faith would you place in that information?

A Long Time Coming Also, the explanation is incomplete. There's no doubt that the Federal Reserve has taken cues from the stock market and has backed away from tighter monetary policies when the market has suggested possible economic slowdowns. This I do not dispute. However, such an approach scarcely began in 2009. It has been in effect for almost 30 years now, since Alan Greenspan became the Federal Reserve chair.

It was under Greenspan's reign, after all, that the term "Greenspan put" was coined--a term that describes this very process of stock prices declining, the Federal Reserve responding by signaling a looser policy, and then stock prices recovering. When Greenspan retired and Ben Bernanke took charge, the effect was renamed the Bernanke put. The results might be new, but the Federal Reserve's mindset is not.

None of which is intended to dispute the general finding. The caveats must be given; it would overstate to regard these results as anything more than suggestive, and it would mislead to imply that the Federal Reserve's signals are more than an extension of previous practices. But I believe that there is something there. I do think that, more than ever, investors tend to react to stock-market declines by seeking out buying opportunities.

I write that not as a putative mind reader--although surely, after listening to John McEnroe describe the thoughts of the players at the U.S. Open, I should be an expert at the practice--but rather as an observer of what has happened and what would be a logical reaction. From my perspective, investors are behaving rationally, adjusting their stock-market tactics in response to broad changes in the U.S. economy.

It's the Economy, Silly To explain: The U.S. economy was once a rocky thing. The first part of the study's time period, 1928 through World War II, was of course extremely volatile. Also turbulent were the 1960s and early 1970s, when stock prices stagnated and inflation soared. Less recognized, however, is the turmoil associated with those two stock-market Golden Ages, the 1950s and 1980s.

On three occasions in the 1950s, real corporate profits were negative during a half-decade period. That is, aggregate U.S. corporate profits, as measured after inflation, were lower in the year that was computed than they had been five years previously. The last time that happened for us was 15 years ago, in 2001. (Yep, that hasn't happened even through the "Great Recession" that began in 2008.)

Meanwhile, inflation jumped like a cat on a hot skillet. The Consumer Price Index was up 7.9% in 1951. It dropped to 1.9% the following year, became negative (that is, deflation) in 1955, and then popped back up to 3.3% in 1957. Contrast that behavior with the CPI during the past five years: 3.2%, 2.1%, 1.5%, 1.6%, and 0.1%.

The 1980s presented even more problems. Not only was inflation a major concern, with the CPI climbing to 4.8% in 1989 and 5.4% the following year, but profit growth was decidedly unstable. On four occasions, including the conclusion of the Reagan presidency in 1989, real corporate profits were negative during a five-year period.

At times of such uncertainty, a sudden stock-market decline might be meaningful. To be sure, not always--then, as now, stocks had a bad day, or week, or month, for reasons that shortly thereafter seemed inexplicable. But sometimes, stock prices were a signal. And there was much to signal. Recessions were frequent. Corporate profits bounced. Inflation was difficult to forecast.

Closing Thoughts The evidence suggests that, in the past, one-day stock-market sell-offs were efficiently priced. The new stock quotes did not offer a buying opportunity, thereby implying that the decline had been overdone. Neither, however, were those freshly discounted stock prices an under-reaction--a reliable indicator to the savvy investor that more trouble lay ahead. Whatever information was conveyed by the stock-market dip was contained within that dip.

Then things changed. U.S. corporate profits and inflation rates became much steadier and easier to forecast. In response, the U.S. stock market has also become steadier, with volatility at record low levels save for the (admittedly massive) exception of 2008. But U.S. stock prices have not become muted enough. They are still too fidgety. In falling by at least 2% about 10 trading days each year, they overstate economic instability. They signal more than they deliver.

Investors have figured that out.

The WSJ article concludes by predicting that investors who have been trained to buy on stock-market dips will eventually receive their "comeuppance." Strictly speaking, that surely must be true--eventually is a long, long time. But I have heard such predictions now for some 25 years, and they have not yet come to pass. Nor will they, until either the dips become fewer in number or the economic fundamentals change.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.