Our Favorite Tool to Buy Great Quality Companies During Market Corrections
When to buy the dip? Getting some help from this indicator
How to Buy the Dip Effectively?
Welcome to another weekly digest. We’ve received quite a lot of questions on when to buy the dip in the stock market. It’s a relevant topic as building wealth in the stock market is a process of buying high-quality growth companies, adding capital to those along the way and keeping your personal risk tolerance in check.
Remember, our goal is to own a portfolio that delivers strong risk-adjusted returns throughout the whole cycle. During periods of economic uncertainty and heightened, we’re here to prove the resilience of our portfolio strategy, that’s where the edge should come from: outperforming during corrections. It’s interesting to notice the increased interest in our Substack over the past month, at a time of more stock market volatility.
As we look at our current portfolio, there will always be opportunities to top up certain positions. Whilst we cannot predict the future (and we’re not even trying to), staying disciplined with periodic purchases can be done through a very simple tool: the VIX index, with the usual caveat that nobody knows what will happen.
The VIX Index
We don’t utilize the VIX to time the market but it’s definitely our favorite metric to define certain levels at which we should consider adding heavily to our existing positions.
The VIX index provides a measure of market volatility on which expectations of further stock market volatility in the near future might be based. The current VIX index value quotes the expected annualized change in the S&P 500 index over the following 30 days, as computed from options-based theory and current options-market data. The VIX can be traded through derivatives (options, futures).
The below graph highlights the relationship between the VIX and the forward 1-year total return for the S&P-500 (we’ve chosen January 2015 - January 2020 to rule out the COVID-19 impact and assess a more typical market environment).
Source: The Compounding Tortoise
Low Volatility = Negative Outlier Risk
When volatility is low, anything can happen: stocks go up because there’s little to be worried about (low inflation, good economic growth, low unemployment). Simply stated, everyone seems to be agreeing on the same positive factors that should keep a stock market rally going.
However, all of sudden, hell breaks loose (risk-parity funds have to rebalance their positions), causing the VIX to rise and oftentimes markets to decline. This is exactly what happened at the beginning of 2018: many funds were shorting the short end of the volatility curve and a little uptick forced them to cover short positions.
Some VIX-linked products that thrived in the calm of 2017 went belly up, and the number of VIX futures open contracts logged its largest percentage decline in a decade. Losses estimated at $420 billion followed a subsequent one-day surge in the VIX during Oct. 2018. Most notably, the VelocityShares Daily Inverse VIX Short-Term Exchange Traded Note (XIV) lost 94% of its value in just over an hour's trading on Feb. 5, 2018 in the wake of a soaring VIX. Its issuer, Credit Suisse, liquidated the product pursuant to a contractual provision.
Empirical Evidence
When volatility is high, a correction/market dip (>5%) has already taken place thus implying less risk for new purchases. Conversely, we don’t think there’s strong evidence in a low VIX predicting poor forward returns for our high-quality growth companies. Corrections come and go, but there’s considerable alpha to be earned when you can stoically buy the dip in fundamentally superb businesses!
Do we have strong evidence to back this up? In other words: is it worth executing new stock purchases on auto-pilot if volatility is close to a specific threshold (e.g. 20%)?
Let’s find out.