Be brave and buy the stock market dip

2022-05-05

That’s a good thing because there is usually an inverse correlation between the mood of investors and the future returns from stock market investments. Not always, because investors can get gloomy well before the market hits bottom, but often enough for sentiment to be a useful signal.

The second measure to look at is the extent to which investors have already priced in trouble ahead. The bond market tends to be a better place to find these signals than the stock market because fixed income investors are natural pessimists and, as a result, better canaries in the coalmine than perennially optimistic equity investors.

The measure I’m looking at today is the yield on safe government bonds. At 3pc, the income from a super secure 10-year US Treasury bond looks to have priced in pretty much all the interest rate rises that are currently spooking investors.

Again, that’s a good sign. I’d be surprised if bond yields go much higher than this for the foreseeable future.

The equivalent measure of sentiment in the stock market is the multiple of earnings that investors are prepared to pay for a share of a company’s profits.

This so-called price-earnings multiple has been falling for more than a year now. Last spring, investors were ready to pay maybe 24 times the earnings of America’s biggest companies.

Today, it’s just 18 times. I don’t have the greatest conviction that this measure won’t fall a bit further yet, but it feels closer to the bottom than the top of its likely range.

The price-earnings multiple is determined in part by price and in part by earnings, or profits. It is a ratio. So, what happens to company profits is clearly important.

The good news on this front is that roughly halfway through the current reporting season (covering the three months from January to March), about 80pc of companies are beating expectations. It’s forecast that profits will have risen by nearly 9pc on average during that period, up from an expected 5pc at the start of the reporting round.

A fifth argument for buying this dip is Mr Market’s tendency to overshoot. Here, it doesn’t make sense to look just at the averages but to seek out the more extreme examples of over-pessimism.

Like the 47pc fall in Cathie Wood’s Ark Innovation ETF, or, closer to home, the 32pc slide in the Scottish Mortgage investment trust share price in 2022. Or Amazon’s 25pc drop year-to-date.

Things are rarely as good as we hope or as bad as we fear, and I wonder whether, when the war is over, inflation has fallen back and Covid has finally been eliminated, we will look back on some of these price movements and wonder why we didn’t act on them.

In the long run, the dips simply disappear from the charts or at least start to resemble harmless pauses for breath. The biggest mistake we can make as investors is to be shaken out of the market by these temporary setbacks. The second error is not to take advantage of them by topping up along the way.

We can’t hope to emulate the investor who only ever buys at the bottom of the dips. We don’t need to. Investing steadily through the ups and downs is a good second best.

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