Friday, June 26th, 2020

Buying Dips & Selling Bounces

There ought to be a special place in hell for the broking analyst who first came up with the statistic that, if you had missed out on the n best weeks of stock market performance during the last n years, your return would only have been x instead of y. Like all really damaging statistics, the problem is that it is true. However, it is only one side of the story, is easily misinterpreted, and doesn’t actually tell you what to do. We thought it would be a useful exercise to review all of the evidence to see what works, and what doesn’t, so that if there is a second wave of the pandemic and a second sell-off, we can have a slightly better-informed reaction function.

We have looked at the data for over forty countries, since the beginning of 1995, based on the weekly total returns in US dollars. We summarise on the basis of the ten best and worst weeks during this period, but if anyone wants the data on another basis, we are more than happy to share it. To qualify for entry in the US, the weekly return needs to be slightly better than 7%, or slightly worse than -7%. For other countries, the median 10th best week is 10.7% and the median 10th worst week is -11.2%. There is a table which shows the detail for each country. For discussion purposes, we concentrate on the 15 most important markets, including the US, and the aggregate for the world ex US.

If you had missed out on the 10 best weeks in the last 25 years, your annual total return for the world ex US would have been 1.7%. instead of 5.4%. It’s the sort of number that ends discussion immediately, but it shouldn’t. If you had missed out on the 10 worst weeks, the equivalent number would have been 10.7%. The uplift from avoiding the bad weeks is far bigger than the penalty for missing out on the good ones. This is also true on a net basis. If you missed out on both best and worst, your return for the world ex US would have been 6.8%, instead of 5.4%, an uplift of 1.4%. We reach the same conclusion, but with different numbers, for each of the 15 major markets we look at – apart from China, which wasn’t a major market until sometime after the 2008 crisis.

Most professional investors should be aware that global equity market returns, in aggregate and in individual countries, are dominated by tail events and that these are negatively skewed. Of course, missing out on good periods is bad, but avoiding bad periods is better. Unfortunately, none of this helps with the really important question: what to do if you have just been through one of the 10 worst weeks in the last 25 years.

We looked at what would have happened if an investor had sold at the end of one of the 10 bad weeks and bought back in one week later. Conventional wisdom is right; it’s normally a mistake to sell at this time, but the result is far more nuanced than one might expect. First of all, it’s not always wrong. For the 15 major markets, it’s only a mistake in 62% of our observations. The best places to apply the rule (of not selling) are the UK, Australia, Canada, Japan and Switzerland, but the rule is wrong more often than not, in France, the Netherlands and India. The biggest penalties for selling out come in Korea, the UK and China, equivalent to an annualised return of about 2%. However, for the US, Hong Kong and Brazil, the penalty is less than 20bps per year, which is easily justified on the basis of risk efficiency.

Second, for the world ex US, investors would have realised a small uplift, equivalent to 21 bps per year, if they had sold immediately after one of the 10 worst weeks. The difference is down to different sample periods; a really bad week in one country is not necessarily a really bad week for the world and vice versa. The result is not significant, certainly not good enough to be the basis for a successful shorting strategy, but it directly contradicts the buy the dip mentality. On a global basis, one very bad week really is often followed by another bad week.

This result is so interesting that we extended the experiment to see what happened two weeks after each of the 10 worst weeks. What happens if we sell at the end of the first week after the crash and buy back at the end of the second? The answer is much clearer. For the world ex US, the cumulative uplift in returns is a massive 1.7% a year. The strategy works 6 times out of 10, and there are two occasions when the penalty for selling is less than 2%.

The strategy works in aggregate in 14 out of the 15 major markets. In some cases, like Germany, Hong Kong and the US, the result is marginal and it doesn’t work in Japan. But for others, like Korea, the UK, South Africa and Australia, the uplift is greater than for the world ex US. The median uplift for the major markets is equivalent to 1.0% per year, and the strategy works for 59% of our 150 observations. Waiting a week and then selling the bounce is a successful strategy.

If we look at the two weeks after a sell-off on a combined basis, we find that investors get an uplift in returns if they sell at the end of the crash week and don’t buy back in until the beginning of the third week. For the world ex US, the annualised uplift is equivalent to 1.9%.

In 9 out of 15 major markets there is an annual uplift, for which the median is 40bps p.a. The strategy does not in the US, but it works surprisingly well in the UK and Australia, and the only really bad result is in China (where the penalty for missing out is equivalent to 2.0% per year).

Our conclusions are follows.

  1. Avoiding the really bad weeks is more important than participating in the really good weeks – always and everywhere.
  2. Really bad weeks are not automatically followed by really good weeks. Sometimes they are, but in aggregate the result is only just positive and cannot be relied on as a trading strategy.
  3. The second week after a really bad week is normally negative. Avoiding this week by selling and buying back later is a successful strategy in aggregate and works for most individual countries.
  4. Avoiding the two weeks after a sell-off is normally better than buying the dip. The only country where FOMO is justified is China. In the other major markets, the penalty is either non-existent or is very small and can be justified on the basis of lower volatility / risk efficiency.
  5. If you buy the dip in week one, don’t forget to sell the bounce in week two.

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