So, You Want to Buy the Dip
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The weekend blowup, explained… Most sectors are still healthy, but these stand out… A three-layered process for optimizing “buy the dip”… How long to hold your trade… The best sector to buy… The best stock in that sector… And one potential reason why…
❖ The weekend blowup, explained…
In describing Monday’s open, we might be inclined to use our most colorful of four-letter words.
The selling seemed to come as if from nowhere. A week ago, the S&P 500 was at 5,500. The CBOE Volatility Index (VIX) was at a calm 16.
Sure, there were signs of distress. Tech earnings were coming in lumpy with unclear visions of how these massive companies were going to profit on the billions they spent on AI…
And seasonal volatility, while no catalyst had yet put it in motion, was historically about to surge.
But it wasn’t until Friday that we got the first taste of what was going on… and not until Monday that we felt the pain.
And boy, did we. From Friday’s close, the S&P 500 fell as far as 4.2% before closing down “just” 3%.
Risk-heavy sectors fared worse – like the Nasdaq 100, which plunged nearly 6% at the lows before closing down closer to 3%.
Crypto has completely broken down, with bitcoin down over 10% and the whole market losing almost half a trillion in value in the span of a week.
❖ If you’re looking for a boogeyman to blame…
You’ve probably heard about the “yen carry trade” being the arbiter of destruction. Allow us to translate the jargon:
- Traders were borrowing yen at ultra-cheap rates – the Bank of Japan’s benchmark rate was between 0% and 0.1%.
- They then deployed that “free money” into other, much higher-yielding assets like bonds.
- But the arbitrage no longer works the way those traders want when the Bank of Japan suddenly hikes rates to 0.25%…as it did a couple of days prior.
Now “the ‘yen carry trade’ is being slammed violently into reverse,” as Justice C. Litle put it in TradeSmith Decoder on Monday…
And “a violent move in a major currency can be one of the most destructive forces on the planet, because the sudden repricing implied by such a move impacts trillions of dollars’ worth of assets.”
❖ In any case, it caused a four-letter-word-ton of volatility…
It was the biggest intraday reading of the year on the CBOE Volatility Index (VIX), and the third biggest of all time. Only the Great Financial Crisis and the Covid Crash were bigger.
(We don’t know what to call this kerfuffle for the moment other than the “Yen Carry” Crash, and we hope something better catches on.)
This seems, to us, unusually high given the somewhat contained nature of the breakdown. It was ultimately a simple leverage event.
Sure, it was a big leverage event, where a lot of traders got trapped in a bad situation and had to endure some pain to get out of it… but a leverage event all the same.
And if you look into the components of all these markets that went down on Monday, you don’t see the disaster the VIX chart suggests.
Take a look at the Health readout of the S&P 500 sectors in our Trade360 database. Some sectors are healthier than others, but none are in dire straits:
We’re seeing the most weakness in consumer-driven sectors like Staples, Discretionary, and Health Care.
That’s not hard to believe – there have been multiple signs of the consumer slowing down. But even these are in mid-term uptrends, with the shortest Green Zone uptrend being Staples at four months.
At the top of the list we see Energy, with the highest distribution of Green and Yellow Zone stocks. Then there’s Financials, with an overwhelming majority of Green Zone stocks. Smack in the middle is Information Technology, the only Yellow Zone sector, with more Yellow and Red Zone stocks than Green.
What I’m getting at is: This is, at least for now, a fundamentally healthy market. This was a bunch of highly levered traders getting caught wrong-footed and falling down the stairs.
So, you might be looking at this and deciding you want to buy the dip. We concur – that could turn out to be a good idea. (And you’ll know as soon as that changes, as our CEO Keith Kaplan will show you in his afternoon edition of TradeSmith Daily.)
To help you do that, we came up with a three-layered analysis method to help you find the best ideas…
❖ It starts with the VIX…
If you want to find past dip-buying opportunities, you have to study the VIX. It goes hand in hand with rapidly falling prices.
Thing is, it’s rare for the VIX to surge as quickly as it did. Like we showed you, it’s only happened two times before.
So, it’s too rare to provide enough data for a good analysis. We can’t study, say, the VIX hitting 60 intraday and have something actually worth looking at.
Instead, we’ll take a look at the times the VIX rose by 30% or more in a single day.
That’s also unusual, but not too unusual. It’s happened 36 times since the SPDR S&P 500 ETF (SPY) launched in January 1993. (Since the VIX is based on S&P 500 options premiums, we’re picking SPY as the most relevant asset relative to the VIX.)
Now that we know that, we can test the forward short-term returns from those moments and figure out the best times to hold stocks.
We went through and tested what happened if you held SPY for anywhere from 1 to 66 trading days after the VIX surges by 30% or more in a single day. (In this study, if a “trade” is on, then other VIX surges of 30% or more are ignored.)
The top 5 hold times, sorted by win rate, are below:
| Hold Time (Days) | Trades | Avg Trade | Win% |
|---|---|---|---|
| 22 | 27 | 1.06% | 81.50% |
| 25 | 27 | 1.22% | 77.80% |
| 29 | 27 | 1.31% | 77.80% |
| 31 | 27 | 1.21% | 77.80% |
| 32 | 26 | 1.31% | 76.90% |
If we’re balancing returns and win rate, then it seems like 29 days is the ideal time period to buy and hold SPY after a day like Monday.
That means, on average, we should expect SPY to be about 1.3% higher by Sept. 12, 2024.
That’s not a big return. And it tracks with our theory that, given the long-term historical trend, stocks may have peaked for the year.
But we can go deeper to find the areas of the market with a better return profile…
❖ Let’s look at sectors in this 29-day window…
Now that we know 29 days is the ideal hold time for stocks after this unusual VIX event, we can test the various S&P 500 sectors and help improve the risk/reward setup.
First, I’ve culled out any sectors that show average negative returns (stay away from Real Estate and Communications). I also skip any instances where one large winning trade skews the data; ultimately, we’re left with the following four:
| Symbol | Hold Time | Avg Trade | Win% |
|---|---|---|---|
| XLV | 29 | 1.8% | 72.00% |
| XLP | 29 | 1.7% | 72.00% |
| XLK | 29 | 0.9% | 68.00% |
| XLU | 29 | 0.9% | 72.00% |
Now we’re getting somewhere. 72% of the time over 25 trades, the Health Care sector (XLV) rises an average of 1.8% after 29 trading days.
But we can do even better than this…
❖ Let’s see which health care stocks are best positioned…
Now that we know the next 29 trading days are the best time to hold stocks after this rare volatility event… and that health care is the best sector to own… let’s dive into XLV and uncover the stocks with the best track record for forward gains.
I took the top 10 stocks in XLV and ran them through this same test. Here’s what we get on the other side:
| Symbol | Trades | Avg Trade | Win% |
|---|---|---|---|
| UNH | 27 | 5.11% | 85.20% |
| ABBV | 16 | 4.61% | 75.00% |
| LLY | 27 | 2.27% | 74.10% |
| TMO | 27 | 1.91% | 74.10% |
| DHR | 27 | 2.52% | 70.40% |
| ABT | 27 | 3.84% | 66.70% |
| JNJ | 27 | 1.96% | 66.70% |
| MRK | 27 | 3.56% | 63.00% |
| AMGN | 27 | 4.13% | 55.60% |
| PFE | 27 | 2.58% | 55.60% |
Of the names on this list, we see both the highest average returns and highest win rate in UnitedHealth Group (UNH), the largest health insurer in the U.S. (Disclosure, I own UNH.)
29 trading days after this unusual VIX surge, the stock runs an average of 5% higher more than 85% of the time.
It should also be noted that UNH held up well over the weekend volatility. It fell just 5% from the all-time high it set a few days ago, which also happened to break it out of a 2.5-year trading range.
So with this multi-layered analysis system, we’ve uncovered the best stock… in the best sector… at the best time… and how long to hold it.
That’s the power of using data to trade.
❖ One last note on health care…
It’s worth noting why, exactly, health care stocks outperform after a major volatility event:
You’ll find a lot of first-rate dividend growth stocks in this sector. The kind of companies you can feel safe holding long term through all sorts of market environments… with nice dividend payouts to help smooth out the ride.
Add in the looming rate cuts from the Federal Reserve, and it’s a very logical approach.
It’s also logical, however, to monitor market health extremely closely going forward. And to only deploy your hard-earned cash into the absolute strongest contenders you can find.
Keith Kaplan just filmed a free webinar all about this with Porter Stansberry, CEO of our parent company MarketWise, LLC.
Suffice to say that Porter, in particular, is unimpressed with what he sees from the market and economic indicators he follows.
He’s warning investors to stay far away from tech stocks, specifically – and to watch out for a bear-market signal from TradeSmith. Go here before midnight on Aug. 7 to learn about the alert system he has in mind.
To your health and wealth,
Michael Salvatore
Editor, TradeSmith