You Call This A Dip?

You Call This A Dip?
Stéphane Renevier, CFA

almost 2 years ago4 mins

  • Despite the 20% drop in US stocks, there are no signs that investors have capitulated, or thrown in the towel.

  • The current drop isn’t historically huge, valuations aren’t historically cheap, and technicals aren’t historically bearish.

  • That doesn’t mean stock prices won't rally, but it does suggest that downside risks remain significant.

Despite the 20% drop in US stocks, there are no signs that investors have capitulated, or thrown in the towel.

The current drop isn’t historically huge, valuations aren’t historically cheap, and technicals aren’t historically bearish.

That doesn’t mean stock prices won't rally, but it does suggest that downside risks remain significant.

Mentioned in story

In the last few weeks, we’ve seen the S&P 500 lose around 20% of its value as investors’ attitude toward stocks has soured. That’s got them speculating that we’ve finally hit “capitulation” – the moment when investors decide to give up on trying to claw back their gains and just cut their losses. But here’s the thing: there’s actually no evidence that we’ve hit capitulation yet, which suggests this dip could dip even further…

What would capitulation look like?

Prices would’ve really crashed.

Looking at past drawdowns – that is, how far the S&P 500 has fallen from its previous highs – shows that the current market drop of less than 20% is smaller than the crashes of 2008, 2001, or even 2020.

Source: Goldman Sachs
Source: Goldman Sachs

In fact, stock prices today remain well above their pre-pandemic highs, suggesting the recent fall is more of a technical correction. In other words, it’s just the index shaking off the excess stimulus from the pandemic era, rather than investors losing all hope on stocks.

Stocks would be dirt cheap.

US stocks valuations recently returned to just below their 10-year average, but the average is much higher than it was in previous decades. So stocks are cheaper, sure, but they certainly aren’t historically cheap. In fact, some indicators – Shiller’s cyclically adjusted price-to-earnings ratio among them – shows stocks as the third-most expensive they’ve ever been.

Source: multpl.com
Source: multpl.com

Also important to keep in mind: valuations generally don’t just stay at their long-term average, but rather overshoot on the downside as investors all run for the exit at the same time. We’re nowhere near that.

Investors would’ve ditched stocks altogether, or changed their positioning.

Institutional investors, retail investors, and high net worth individuals have all reduced their stock exposure recently. That being said, they still remain heavily invested in stocks, and even the amount invested into stocks hasn’t been as meager as you might expect, given all the headwinds. An extreme example is ARK Invest’s Innovation Fund (ARKK), which has seen inflows despite losing almost 80% of its value.

Looking at safe-haven assets like gold, the Japanese yen, or 10-year Treasury bonds is also telling: there hasn’t been a so-called “flight to quality”, like there has been during previous capitulations. That’s partly because those safer assets also suffer from rising interest rates. But if investors were really expecting the worst, those havens would be more popular than they’ve been lately.

Investors would be panicking.

While most technicals clearly show that investors have turned more bearish, they’re still far away from levels seen in previous capitulations.

Take the Cboe Volatility Index (VIX): this is Wall Street’s “fear gauge”, an index that shows what kind of volatility investors expect in the near term. At a value of around 28%, the VIX is certainly above its long-term average of around 18%, and shows that investors are expecting a difficult environment ahead. But it’s nowhere near the 80% level it reached in 2008 and 2020, and well below previous peaks of around 50%.

Or take market breadth (the number of stocks reaching new highs) and the put-call ratio (the volume of calls in relation to those of puts). They’re painting a similar picture: investors are bearish, but not as bearish as they were in past crashes.

Even technical analysis indicators like Fibonacci retracements show we’ve reached only the second significant support level – when prices retrace 38% of their previous gains. There are three more levels below before stuff gets really dicey.

So what does this tell us?

The temptation right now is to buy the dip because prices – and investor sentiment – is suddenly lower. And it’s true that this can be a good strategy if investors have capitulated. But clearly, there’s been no evidence of that.

Now, the point here isn’t that prices will necessarily go lower, so you should hold off to buy the dip. Nor that stocks can’t rally unless investors have capitulated. It’s just a reminder that we haven’t seen evidence of a real capitulation. That has two important implications.

First, rallies are more likely to be short-lived and swiftly reversed. So be cautious about buying any dips in the meantime. And when you do buy, make sure your positions are small enough so you can handle a potentially larger loss. And second, capitulation may still be coming. Make an investment plan, and be prepared to buy in the event we experience a real capitulation. That’s when the risk-reward will be most interesting, and when you can make serious profits…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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