Fra Zerohedge:
A strategy of holding cash and buying any 5% dip in S&P until markets retrace the loss has outperformed the S&P consistently since 2014, but as BofAML warns, the changes in inflation market dynamics post-Trump may “handcuff” The Fed and pull a key support out of the market that helped create the “buy the dip” trade.
One of the most important aspects of central banks’ policy control of volatility has been their unprecedented sensitivity to financial market conditions, with promises for support even during minor shocks to markets.
This has completely changed market dynamics in US equities, for example, by teaching investors that the safest trade is to buy the equity dip or even fade the volatility spike. As a result, volatility spikes have been crushed at record speed and equities have traded in ultra-tight trading ranges which have significantly depressed US equity volatility.
In a market where traditional investing methods are generating their poorest performance in years, investors have been increasingly incentivized to adopt “buy-the dip” as a core alpha strategy. It has become even more attractive since 2014 as equity market returns have stalled (Chart 6).
However, the strategy has also become increasingly crowded with dips more rapidly bought. For example, during the 2016 US Presidential election, as it looked increasingly likely that Trump would prevail, S&P fell limit down (-5%) in the overnight session, however, reversed all of these losses to close higher by the next day. As a result, markets set a record in terms of moving from high stress to calm in a short period, with the previous record reversal in volatility set following Brexit. (Chart 7).
A significant potential change in the recent dynamics of US equity markets is a failure in the buy-the-dip trade. This would help to end these record V-shape recoveries in markets and crashes down in volatility resulting in a more prolonged vol cycle, where volatility spikes-up but gradually drifts (instead of crashing) lower. So what could kill the buy-the-dip?
One-two–punch: A shock that investors initially buy equity/sell volatility into but which is followed by a secondary shock creating larger losses
Inflation handcuffing the Fed: A key question is with rising inflation and inflation expectations, whether the Fed can remain as sensitive to financial market conditions. Any significant market shock in which the Fed is visibly absent (if they are no longer able to threaten to stay on hold for longer), would pull a key support out of the market that helped create the “buy the dip” trade.
Strong equities pulling high cash levels out of the market: Running higher than normal cash levels and using this cash to buy-the-dip only outperforms “buy-and-hold” if, 1) equity returns are not too strong, 2) there are a sufficient number of dips to buy into, and 3) markets consistently recover from these dips. If prospects of US stimulus drive significantly higher equity returns (our equity strategists bull-case), this will ultimately pull the large amount of cash held by investors off the sidelines, leaving less “dry powder” and putting markets at risk from investors selling (rather than buying) dips
