Finance

BANK OF AMERICA: A wildly successful stock-trading strategy is no longer working — and it signals that a bubble has burst

trader upset distraught Reuters / Brendan McDermid

  • An extremely successful and long-standing stock market strategy is no longer working, Bank of America Merrill Lynch says.
  • The firm argues its failure is symptomatic of a broader shift taking place in markets — one that could mean far more volatility.

For much of the nine-year bull market, the stock-trading strategy known as “buy the dip” was basically synonymous with “free money.”

That’s because, following any period of sharp weakness, traders could simply scoop up shares at bargain prices, and the market would recover.

Bank of America Merrill Lynch went as far as to crunch the numbers, and the results are astounding. Dating back to 2012, buying any 5% dip in S&P 500 futures — and holding until either the move retraced or 20 days passed — would have been successful 82% of the time, the firm’s data found. Further, since 2014, BAML says, such a strategy has consistently outperformed the benchmark.


Buy-the-dip has enjoyed an 82% success rate since 2012.
Bank of America Merrill Lynch

Sounds great, right? Well hopefully you enjoyed it while it lasted, because BAML says the buy-the-dip well has run dry in 2018.

And while it may be your immediate instinct to move on to the next foolproof strategy, the implications of the strategy’s collapse are wide-reaching and could reshape the market as we know it.

At the core of buy-the-dip’s failure is the Federal Reserve, which BAML says indirectly ingrained the practice into the minds of traders through monetary accommodation and a slow pace of tightening. The firm says that lulled investors into a sense of security, which explains the near-record-low stock-market volatility seen in 2017.

“The moral hazard injected by central banks in recent years teaching investors to buy-the-dip (or sell the vol spike) helped create the least volatile markets in 100+ years, and a low-vol bubble,” Benjamin Bowler, BAML’s head of global equity derivatives research, wrote in a client note. “This led to complacency among investors that risk was not real, resulting in an unsustainable ‘low vol bubble.'”

It’s that last part in particular that should catch the eyes of traders. BAML is saying the historically minimal price swings that characterized so much of 2017 are a bygone relic of the past. The firm argues that volatility is now elevated as recent headlines are “injecting fear back into the markets,” and all bets are off.

The volatility complex has also rid itself of two controversial exchange-traded products that imploded in early February, erasing nearly $3 billion in mere minutes. The popular practice of shorting those ETPs was long blamed for stifling price swings and inflating the low-volatility bubble. And then, when it all came crashing down, they were blamed for exacerbating price losses in the broader market amid forced position covering.

But what about earnings season? Shouldn’t it have a stabilizing effect? Not quite, says BAML, which thinks even a strong batch of corporate reports will be futile to stop the new high-volatility regime.

“Even if US equities do end up recovering to set new highs in 2018, perhaps on the back of a strong earnings season, simply breaking the trend of rapid recoveries (and the Pavlov buy-the-dip mentality), should prevent a return to the 2017 bubble lows in volatility,” Bowler said.

“While that should create a new higher floor for vol in 2018, we also see today’s current level of S&P volatility as unlikely to last unless equities sell off further, resulting in broader contagion across markets.”

Click to comment

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Most Popular

To Top