Defend. Defend. Defend. Attack!
Here’s some good news: the notion of “buying the dip” seems to have largely disappeared from the FinTwit vocabulary. This strategy works well in a bull market, when everything just bounces off the moving average or lower trendline and stays in an ascending channel. Share prices “only go up” and so does the value of your portfolio.
On the way back down, buying the dip is a cunning way to ruin your portfolio. In bear markets, you’ll find that patience is rewarded. In contrast, the ongoing buying of every dip is punished.
It sounds like a 1960s country song: those dips keep on dippin’ and so does your portfolio value. This can quickly lead to feelings of hopelessness and failure, emotions that you need to do everything in your power to manage. Unless you’re a trader living off your profits or you are buying on leverage (for example, with contracts for difference), you can afford to have “mark to market” losses: that is, positions that are in the red, hopefully temporarily.
The same long-term strategies apply in bull markets and bear markets: buy good companies and hold them for as long as the investment thesis remains intact. The trick is to buy them at the best possible multiples over time.
In a bull market, you can still find companies trading at a reasonable price. You just need to avoid buying the froth, which in the latest cycle was found in the tech companies.
In a bear market, you need to avoid buying anything too early or buying businesses that are likely to come under further pressure before things improve. Some businesses are resistant to recessions and others are sitting ducks.
Time value of money is also an important consideration.
There’s no point tying up capital in a dropping share price when it could be in your mortgage instead. If you don’t have any debt, you could seek out a short-term fixed income product or even an alternative investment, which can range from private debt funds right through to blueberries. There are many ways to grow your wealth that have nothing to do with traditional equities.
When equities finally start to look more affordable, remember that things can still go lower. If everything traded at fair value all the time, the markets would be boring and there would be far fewer people working in the industry. The combination of human emotion with bull and bear cycles tends to result in bull markets overshooting fair value and bear markets taking stocks below their fair value.
The assessment of fair value in these conditions isn’t straightforward. Be cautious of using trailing multiples (that is, based on the most recent financial year’s results) as this may not be a reasonable indication of the results for the coming year.
The use of forward multiples is important, as this compares today’s share price with your best expectation of earnings in the next financial year. Of course, this requires you to forecast what those earnings might be.
Absorbing the pain
Forecasting isn’t easy. If this game were easy, everyone would be a stock market millionaire.
Building in a substantial margin of safety is a sensible approach. If you think a stock looks cheap, consider how conservative you have (or haven’t been) in forecasting earnings.
Put together a proper “bear case” with assumptions that make you cringe. If the company still looks cheap, then it may be a buy. If it starts to look marginal, then tread carefully.
Remember, Covid’s impact on the broader economy was cushioned by unprecedented central bank stimulus — we don’t yet understand how bad the stimulus hangover might get.
I would also suggest that you prioritise companies with strong balance sheets. A company can absorb all kinds of pain if the balance sheet is strong. When there’s no cash, even the most exciting companies can become nothing but a distant memory. It’s almost impossible to raise capital in a bear market at a reasonable price, so companies that didn’t emerge from the 2020/2021 cycle with flush balance sheets are best avoided.
Finally, be careful of bear market rallies. They can be sharp and shortlived, drawing you in and then punishing you for giving in to temptation. It’s better to wait for a consolidated bottom and miss out on some of the upside before climbing in.
When that day comes, make sure your shopping list is ready. In the meantime, focus on doing detailed research while letting your money safely earn a fixed return somewhere.