Friday, May 7th, 2021

So, You Want to Buy the Dip

In our last note, we set out some of the indicators that suggest we may be close to a peak in risk appetite. They include the main equity vs fixed income models denominated in both US dollars and euros, US High Yield vs US Treasuries at maximum overweight, Gold vs a balanced portfolio at maximum underweight and cyclical equity sectors at peak exposure relative to defensives in Japan, the UK, and the US. Trying to pinpoint the peak in real time remains as pointless as ever, but the performance of Nasdaq in the last two weeks, after some spectacular earnings from Big Tech, may be another indicator that risk-appetite is peaking.

Almost every client we speak to is hoping for a correction so that they can increase their equity exposure. Hope is a poor basis for prediction, but this could easily become a self-fulfilling prophecy. After the phenomenal performance of the last 12 months, a correction in global equities does not require significant selling pressure. All it needs is an absence of buyers. There will almost certainly be a catalyst, but in our view, this will just give narrative cover to something that was likely to happen anyway.

So, our first recommendation is that investors should welcome the correction when it comes and not overanalyse the reasons for it. They should specify their reaction function in advance. The tactical trigger can be expressed in terms of an absolute level on a broad equity index or as a percentage drawdown from the peak. If you have waited all year for an opportunity to buy the dip, make sure you actually do so when it happens. It also makes sense to do it in stages: say one third of your budget after a 6% drawdown, followed by another at 9% and another at 12%, if we get that far.

Our second recommendation is that investors should be clear about their objectives. Buying the dip is an exercise in market timing. Combining it with a change in your regional allocation within equities will only add complexity to the trade. If you want to reduce your exposure to Emerging Markets and Japan, as we recommend, or increase exposure to Europe, you should be doing that now, irrespective of your view on the possibility of a global correction.

Our third recommendation is that investors should apply the same logic to sector strategy. Reducing exposure to US Small Caps and increasing exposure to Financials does not depend on timing the correction. We are already neutral on US Technology and Consumer Discretionary, two of the sectors which would be most impacted by a correction. If you are still overweight, we think you should reduce this, not because a correction is coming, but because they are already not as risk-efficient as you think. The same logic applies to our views on Technology in Europe and Asia as well.

The only exception to this rule is defensive sectors in the US and Europe. We are currently underweight, but we would expect to increase exposure after a correction because these sectors would become more risk-efficient on a relative basis. However, it seems a pity to wait until after the correction to increase exposure to low beta sectors which would suffer less. If we had to pick one sector where we are prepared to front run our recommendation it would be Telecoms in Europe.

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