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Buying on Stock-Market Dips Is Logical

A big change in investor behavior has an economic explanation.

John Rekenthaler, 09/16/2016

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.

is vice president of research for Morningstar.

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