Buy Strength or Buy the Dip?

To judge from my own experience, buying the low of a move is very gratifying. Unfortunately, it doesn’t happen often. Usually, the price goes lower. In many cases, especially with stocks, the price usually recovers after some uncomfortable days.

I intentionally did not say “Buy Weakness” in the title. It implies too much negative, and there are strategies in which buying the dip works.

Let me tell you how this month’s topic occurred. I was looking to write about green energy and green companies. I found a website by a major institution that was recommending stocks that would, in their opinion, outperform in 2022. They are:

• Beyond Meat (BYND)
• Hannon-Armstrong Sustainable Infrastructure (HASI)
• Sunrun (RUN)
• UGE International, Canada (UGE)
• Tesla (TSLA)
• TE Connectivity (TEL)
• Infineon Technologies, Germany (IFNNY)
• First Solar (FSLR)
• Vesta Wind Systems, Denmark (VWDRY)

These companies range from building electric cars to providing solar energy and reducing carbon output. There is no doubt that the world is heading in that direction, sooner or later.

Comparing Performance to the S&P and Nasdaq

Before judging these choices, let’s see what their price history looks like, and compare them to the S&P and Nasdaq using SPY and QQQ. We will need more than one chart to be able to see the returns clearly.

Figure 1 shows the prices of SPY and QQQ. Even with the recent downturn, there are substantial gains over the past 12 years.

Figure 1. The equity index ETFs, SPY and QQQ.

The first four of the recommended stocks are shown in Figure 2. The prices have not been adjusted so they begin at different places in 2010. BYND did not start trading until 2019.

Figure 2. Unadjusted prices of the first four stocks.

In Figure 3, the second four stocks are separated, with RUN, TEL, and VWDRY on the left scale and TSLA on the right scale. Without doing that, you would not be able to see the pattern of the other three.

Figure 3. Unadjusted prices of the second four stocks, with TSLA on the right scale.

What do these eight recommendations have in common? All of them are in a sell-off, well off their highs. I’m going to assume that they are recommended because they are strong companies and undervalued. The question becomes “is this a good time to buy?”

Value Investing

The goal of value investing is to find companies that are priced below their intrinsic value. Most stock analyst rate stocks as a “buy” or “strong buy” by how much price is below value. Examples can be found on Yahoo Finance if you scroll down on the right side of the GOOGL chart. Figure 4 shows a recent history of analyst ratings, their target price, and how that price compares to the current price. It’s a good resource for a value investor.

Figure 4. Yahoo Finance analysis of GOOGL.

Rules for Buying Strength or Buying the Dip

Before explaining the rules, you should know that I buy strength, so you need to be careful of my bias.

Buying Strength

Buying strength takes advantage of two important features: nearly all stocks keep going up, even though they have periods of drawdown and sideways trading. You can see that because the equity index markets keep going up.

The second feature is persistence. Stocks that are going up are most likely to keep going up. The stocks that are strong are the most likely to continue. We can’t predict how long they will continue, but it will be enough to generate a profit.

Using a trend is a good way to identify if a stock is going up. Use a trend of at least 40 days, best if it is 80 to 100 days to capture the bigger picture. If the trend turns down, you have an impartial judgment that you should exit and wait for the trend to start up again.

Buying Weakness

When a stock price is going down where do you buy? How do you know how far down it will go? How do you know it will go up after you buy?

While you get a good price, you are participating in a negative scenario. Is the stock going down because the company is failing? Is it going down with the rest of the economy and is not a reflection of its own management?

The only assurance that a declining stock is a good buy is that the analyst assures us that the company is financially sound. Even then, we have no way of knowing when the stock price will turn up.

One of the biggest faults in value investing is that there is no timing. The stock could turn up tomorrow or next year. None of us have a clue.

Buying a Dip

Now I want to distinguish between “buying weakness” and “buying a dip.” I see “buying a dip” as a smaller downturn within an uptrend. The long-term trend (40 or 80 days) is up, but prices have declined. You can buy and still use the trendline to tell you when to exit. A drawdown that does not break the uptrend is not going to be severe.

While you can improve your entry timing buying a dip in an uptrend, it reduces the number of opportunities. It is a good method, but you will need to scan stocks to find enough to qualify. And you want to see that this method worked for that stock over the past few years. The stock will need to have had a clear trend with moderate reversals.

Conclusion

Of the eight stocks in Figures 2 and 3, TSLA, TEL, and perhaps HASI and IFNNY are pullbacks in an uptrend. BYND, RUN, and FSLR would all be in a downtrend. You can easily verify the trend on any trading platform.

Before deciding to trade a stock because your brokerage firm says it is undervalued, check it out yourself. Be sure it is still in an uptrend and that you know where it will turn down so you also know the risk.