What stocks to look at for 2025...
Here's what investors are doing as Mr. Market pulls back going into 2025
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“Should I buy the dip?”
Written by Logan Shearer:
So the market is dipping again. Not necessarily even correcting. The S&P500 is down about 3.5% over the past month o some short term weakness related to inflation and projected interest rates. The Russell 2000 is in correction territory being down in the high teens percentages quickly approaching “recession territory” and the question is inevitably popping up, buy the dip or wait? As always Bluechippers is here to help.
Plenty of people like to quote Ben Graham’s characterization of Mr. Market as a manic depressive which will offer you ridiculously good prices to sell into and ridiculously cheap prices to buy at but the simple reality is that Ben Graham ran a portfolio of actively selected individual stocks in a time before index funds and in a time before the history of market panics was ever studied. While I am a creature of the exceptions, finding exceptions to the theory, data matters especially for the population level of investors that just want to do what is best for their future.
There are three separate approaches to what I would call “market timing” there is dip buying, which is based on price action, the market tends to go up, but if the market goes down a certain amount over a certain time, buy more. There are valuation and factor based analysis that put more capital into the markets when it looks relatively cheap and pulls back when it is relatively expensive. These are the only two strategies that are directly comparable to dollar cost averaging.
Dollar Cost Averaging or DCA is the process of “automating your investments” say you want to invest 500 dollars a month in a portfolio of the S&P500. That is just what happens. You set up your accounts so 500 dollars goes from your bank to your broker and from your broker to the S&P, you average up when the market is going up and average down when the market is going down. At the end of the day though DCA means always being fully invested. This can spook some people who get concerned about investing in a continuously rising market or buying when the market keeps falling. The way I get over these hurdles is to use the best available data.
THE EXPERIMENT
The very first leg of the experiment is related to moving averages. Moving averages are a type of technical analysis that wants to either buy or sell based on where the market is priced at a certain point in time relative to a price in the past. First I utilized a model where the model purchased The S&P500 at the end of each month where it was higher than the average price three months ago. I did this with a few different averaging techniques and the results were basically the same. The returns were approximately half of those of the buy and hold portfolio. The risk-return was also worse.
One key factor is the presence of other cash flows. If you only invest an initial amount the risk return and total return profile of the market timing models improve. But with continuous reinvestment, which is how most retirement portfolios work, DCA wins. Other adaptive allocation models that shift between SPY and a broad bond market index like BND seem to perform better, although still not as well as DCA, the extra problem with adaptive models is the monthly reallocations which will increase time spent and trading costs.
The final leg of the experiment was to use the Shiller PE valuation model which looks at a seasonally adjusted market valuation average to adjust for weird fluctuations in valuation due to seasonality. If the Shiller PE is below 14 the portfolio is 80% stocks 20% bonds, if the Shiller PE is between 14 and 22 60% 40% stocks to bonds. If the Shiller is above 22 the portfolio is 80% bonds 20% stocks. When this is compared to a whole stock portfolio, a 60/40 portfolio and a whole bond portfolio some weird things happen.
Going back to 1985 through November of 2024 the following shows the results
The valuation model does have a few upsides. The returns on a risk adjusted basis are much better than any of the others, the smallest drawdowns and better returns than the bond portfolio. There is one problem though, if you extend the data back as far as it can go, to 1972 the valuation model loses even the risk adjusted edge to the balanced portfolio.
In any event the problem with simplistic timing models is that they look at very few factors. There is always something to worry about. But for most people Dollar Cost Averaging into a whole stock portfolio is going to grow wealth, investing in a 60/40 for the more risk-averse investor may also be good, but ultimately timing the index is typically a fool's errand that hurts long term returns.
So why do the best investors do it?
Some of the best investors in the world like Warren Buffett, Bill Ackman, Seth Klarman, ad many hedge funds market time. Why? The answer is simply that they don’t think of the market as a whole but rather finding the deals within it. Berkshire Hathaway owns 40 stocks. Even this is a lot but it has to be this way. The portfolio is over a quarter of a trillion dollars and Buffett needs to find companies that they can take an initial position and own less than 5% of the company. Buffett needs to find companies that exceed 20 billion or so to even start looking, then he needs to find companies that are really on sale. This is why, of the 40 stocks in his portfolio more than 80% are in the top 10.
Seth Klarman owns 20 stocks in a 3 billion dollar portfolio and nearly 50% is in his top 3. Bill Ackman owns 10 stocks(9 if you combine the two different Google Share classes) and considering the fact he has bought fewer than 10 different stocks unrelated to spinoffs or transactions of companies he already owned in the last five years it is fair to say he picks his spots very carefully. Market timing basically loses its meaning at this level. Investors with fewer than 30 stocks are paid to be different from the market, not just to find a way to time it and get returns but to find the best performers in an ocean of companies. What should investors that want to emulate the best in the modern day do?
Learn to take the pain of losses. Warren and Charlie have often said that you should not own a stock that you could not feel comfortable holding if it went down 50% for no reason. While this is solid advice sometimes we are just wrong, and the picture below perfectly captures the feelings of many value investors who have found what they feel to be an undervalued quality company that just keeps going down or staying flat.
In all seriousness, investing is going to be painful sometimes. There has to be a level of emotional regulation and return on brain damage to make everything worth it. Dollar cost averaging into the market is so simple, yet so effective. The goal should be to eliminate the traditional concept of market timing from your mind altogether. Either DCA into the market or be on the lookout for bargains. That is how returns are made “buying the dip”.
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