Behold, we have a market slip, so what should you do? Hint: try buying the dip

A nine-year bull market in equities is facing one of its sternest tests as the surge in volatility which began at the end of January intensifies.

In the first two months of this year, the benchmark S&P 500 index notched up 15 days in which it moved 1 per cent or more in either direction, nearly twice as many as in the whole of 2017, according to data from Bloomberg.

The bout of turbulence has become even fiercer over the last few weeks.

Since March 9, the S&P 500 has dropped 6 per cent. On Tuesday, tech shares, one of the most popular investments over the past couple of years, took a pounding, partly due to the fallout from the data mining scandal at Facebook. In a sign of the extent to which sentiment in equity markets has deteriorated, a tech index grouping the FANG block (Facebook, Amazon, Netflix and Google) and several other large companies suffered its sharpest decline since its inception in September 2014.

The “buy the dip” trading strategy – loading up on stocks whenever the market declines in expectation of a swift rebound – that has worked wonders with global equity investors over the past several years appears to have finally run its course.

On closer inspection, however, the jury is still out on whether investors have decided to stop buying on dips and instead sell into rallies in stock prices.

The evidence so far hardly points to a full-blown bear market.

Despite the sharp price declines since the end of January, the S&P 500 is down just 2 per cent so far this year, and up 11 per cent over the past year. Moreover, global stocks, as measured by the FTSE All-World Index, are also down only 2 per cent this year while the MSCI Emerging Market Index, the leading gauge of shares in developing economies, has risen more than 2 per cent. Emerging market equity funds, moreover, have attracted US$44 billion of inflows this year – nearly 40 per cent of last year’s total.

Volatility, as opposed to capitulation, is the watchword.

As recently as Monday, the S&P 500 enjoyed its best day since China’s surprise devaluation of the yuan in August 2015, surging 2.7 per cent and accentuating the sharp increase in volatility compared with the exceptional tranquillity in 2016 and 2017 when the benchmark index went through long periods when daily moves in stock prices did not even exceed 1 per cent in either direction.

Make no mistake, equity markets are readjusting to a more normal volatility environment.

While this may be painful for investors – particularly those exposed to the popular tech sector whose dizzying price gains over the past two years turbocharged the bull market but which has become the epicentre of the latest sell-off – it is not a sell signal in itself.

A number of key factors continue to underpin equities, suggesting that the dip-buying mindset will prove hard to shake.

The most important one is corporate fundamentals, particularly in the US, which remain strong despite the increase in volatility. On Wednesday, the US Commerce Department announced that the economy grew at a faster-than-anticipated annualised rate of nearly 3 per cent in the final quarter of 2017. According to Bloomberg, American companies are enjoying the sharpest increase in earnings since 2011, buoyed by corporate tax cuts and the rebound in global commodity prices.

Just as importantly, one of the biggest threats to stock markets – rising inflation and a spike in government bond yields – has become less acute. Bond yields, as I argued in my previous column, have fallen sharply since late February, partly because of concerns about growth, especially in Europe. Lower bond yields provide a cushion for equity valuations, which in the US are still exceptionally high.

Indeed a correction in stock prices, provided it does not turn into a bear market, is no bad thing given how expensive US shares have become. Even after the recent declines, the so-called forward price-earnings ratio of the S&P 500 is still 11 per cent above its long-term average, according to Bank of America Merrill Lynch. Cheaper valuations, underpinned by robust fundamentals, present a buying opportunity.

Still, the surge in volatility is not for the faint-hearted.

The strain on overbought tech shares, particularly Facebook whose privacy scandal has already caused its stock to plummet 17 per cent since March 16, threatens to infect the wider market.

Yet even the tech-heavy Nasdaq Composite index remains in positive territory for the year, hardly a sign of a meltdown. The dip-buyers still have reasons to be sanguine.

Nicholas Spiro is a partner at Lauressa Advisory