Buying on Pullbacks in Current Market Conditions

Markets

We are often told by people looking to advise us on managing our stock positions to look to enter on a pullback. We need to understand the rationale before we decide to leap.

Anytime markets are moving up, which they certainly are now with the right stocks anyway, it’s common that people who are paid to give us advice will advise to enter rising stocks on a pullback.

We’re not told how to do this, or what the reasoning is behind such a strategy, where we are at least presumably looking to trade a stock more optimally than just buying the thing now and keeping it for a while. It’s even questionable that these people who tell us that they are waiting for a pullback have much of an understanding of these things that they may share, apart from the idea that their approach would have them entering at a price lower than it may be now, even though that isn’t even a given.

Buying on pullbacks certainly has its place and time, and we saw some epic opportunities to use this strategy after the huge pullback we saw this past February and March. We need the right conditions to make sense of such a thing, as this is a counter strategy and it’s certainly not a good idea to use a counter strategy as a general strategy like so many people do, because this will have you running counter to the norm, not a good idea if you wish to succeed.

There is also a big difference between taking advantage of an opportunity to buy a dip and sitting around doing nothing waiting for one, making this a prerequisite for your entry. What this ends up doing is limiting yourself to a particular entry strategy, where there may be other technical reasons to enter, the fact that something is continuing to rise in price for instance.

That happens to be the prevailing way to make money in stocks, something that should be quite obvious to anyone with even a casual understanding of how stock markets work. Stock prices go up over time and some go up more than others and only a small percentage of these overall gains are a result of pullback inversions.

We hear things like someone missing taking advantage of the last pullback with Apple or some other high-flying stock that tends to scare a lot of these money managers that tout this buying the dip strategy, where we’re told they are waiting to buy another dip while the stock’s price continues to climb.

This seems reasonable enough to them or they wouldn’t be sharing this with us, with at least some sort of presumption that some investors who are watching may seek to join them in their quest to wait for a better price in their mind. Just the fact that anyone would wish to limit their entries such a thing already tells us that they are not doing a whole lot of thinking about this, and even though that may be the norm, to not question our investment strategies very much, we cannot just pretend away the need for this.

Buying pullbacks is mostly a trading strategy, which can be modified to be used by investors by focusing on investor-sized dips like the one we saw materialize with stocks toward the end of March or to start the year in 2019, versus the much smaller ones that traders use to take advantage of shorter term overselling. This is all about capturing value that has been oversold though, whether the pullback is by a third or a third of a percentage if you are a high frequency trader.

To play pullbacks properly, you need to understand what we are trying to do by looking to capture these moves. Pullbacks involve a time where supply exceeds demand for a stock in a way that is temporary, where demand is expected to regain control, and when it does, and only when it does, we can look to capture a good portion of this temporary dip.

We’ll use Apple to illustrate some of the do’s and don’ts of buying dips, although the process and the strategy remains the same, where some stocks like Apple may provide greater opportunity to do this due to both their stronger upward bias and their volatility.

Stocks that go up more normally but pull back significantly during dips are the perfect candidates for this, and we need at least a good amount of this higher potential to make this type of trade competitive with what else we could have our money in, including being in a better looking stock as far as cashing in on this pullback strategy at any given point in time.

A lot of stocks dropped by 30% or more during the recent stock market panic, and Apple’s 31% loss was pretty typical and it actually gave up less than the 34% that the S&P 500 dropped, in spite of people thinking that Apple is a stock that can be expected to go down a lot more than the market does in times of crisis.

It is not enough to just buy a stock while it is dropping, and that’s a stupid and dangerous time to enter in fact, as we need to wait until the selling pressure subsides before it becomes safe enough and wise enough to jump on. Once things did start to pick up, it was clear that these stocks just didn’t lose a third of their longer-term value but did so in response to this temporary supply shock, where the selling in this case was precipitated not by longer term concerns but by traders fleeing the decline while it went on.

The opportunities to recapture temporary losses due to this selling pressure abounded back then, although we still need to be selective here. Some stocks shot up as Apple did, others did considerably less well, and some didn’t even put in much of a bounce at all. The distribution here wasn’t really much different than we see in a normal market, where the good stocks resume their goodness and those not so much in favor resume their relative out of favor-ness.

What’s most important to realize about using this strategy is that you need the right conditions to use it, whether it be by investors buying the bigger dips or traders trading one second bar charts and capitalizing on very short-term order flow imbalances. Someone puts in a bigger order and this temporarily drives the price up or down more than it would be otherwise.

Traders play both sides of this, and this is why we see so many ups and downs on even the shortest of timeframes, but this is just one of the tools they use, with the other major one being riding momentum.

Going to a longer trading timeframe allows us to filter out smaller ups and downs on the way up, or on the way down if you are trading the short side, on the way to higher prices on the long side or lower prices on the short side. Both of these scenarios are very much situation dependent, although there is considerably more opportunity to ride momentum than to play reversals because of the way these opportunities are distributed.

If You Try to Live on Pullbacks, You Will Starve Yourself

From the perspective of investors, the opportunities that they have had with a stock like Apple has been mostly on the momentum side, and investors don’t usually trade pullbacks anyway, which involve getting out when the overselling is happening and getting back in for the reversal. Even if they did, and didn’t manage to botch things up, most of the money that has been made in Apple has been from holding it during the mostly good times where even ignoring pullbacks completely has provided some very princely gains for them over time.

The better our strategies match up with what really goes on in the market, the more success we will have. What we are out to do with our trades and investments is to seek to capture appreciating value from our perspective, where if we’re on the long side we’re out to be in stocks that are appreciating in price significantly, whether that’s after a pullback where we get back value temporarily lost or are looking to ride stocks up during times where they are simply moving forward generally.

Now that we have an idea of what buying on pullbacks serve to do, what advantage a move like this may present when the right opportunity to do this presents itself, and especially the fact that this is a supplementary strategy and a subset of the wider strategy of momentum investing, we are now ready to look at all the banter we continue to hear about surrounding money managers wishing to limit their entries to pullback scenarios and why this is such a poor strategy overall.

It does need to be pointed out that this strategy that is being even more espoused in today’s wacky stock environment is not an investment strategy, at this point in time anyway, and investors aren’t really going to worry about these things very much apart from the big pullbacks perhaps, and is instead an attempt by investors to wish to become traders of some sort, even though they still may call themselves investors investing this way.

What they are really seeking is to become momentum traders, but only taking one particular strategy used by momentum traders, the smaller part of what they do, and ignoring the better part of what this seeks to do. The people who tell us to buy on dips are also quite fundamentally oriented, telling us things like a stock may look pricey and such, concepts that are foreign and irrelevant to the type of trading they inspire to, furthering their confusion.

Buying pullbacks is a purely technical play, which is the case whenever we let the price of something guide us rather than something else that is independent of trading prices. What we do when we employ this strategy is to play a reversal of a reversal, and this therefore can present some tactical advantages but it certainly isn’t something you would want to use as a general strategy with a stock, because the stock may present other and even much bigger opportunities by trading it with other tactics, such as jumping on Apple and holding it as it continues to climb.

If we instead seek to portray playing a stock like this as a process of waiting for pullbacks, we’re going to miss a lot while we wait. If we insist on picking our stocks this way generally, this will have us directed toward plays that may be inferior, which is another mistake.

Together, this can have us passing up the great opportunities because they don’t fit our limited view of how to trade it, and instead select pullbacks on a momentum play that simply don’t have enough momentum to make these trades appealing, especially in comparison to what may be made with a hotter stock that is getting even hotter.

What pullbacks serve to do is to add additional room to momentum plays, where in addition to the progress that these stocks make, additional amounts can be potentially earned though recapturing what was sold off due to negative momentum. Apple was doing great, it dropped by a good amount earlier in the year, and buying it after the pullback allows you to make this extra in addition to wherever it wants to go after it recaptures that.

If you wish to play a pullback with a momentum stock and want to do this right, if the stock is worth trading, this will mean exiting pullbacks of a significant enough magnitude to capture your attention and then the re-entry gets you back in at a lower price and the difference is your additional profit, over those who do nothing during these times.

Generally speaking, the pullback itself isn’t a good reason to enter a stock if you are only there for recapturing the pullback, unless there is a real good reason that has a play stand out enough. If it’s not good enough to keep after the gap gets filled, it’s rarely good enough to even bother with the pullback as well. If you look to segregate your Apple trades this way for instance, you may get a portion of its movement over time this way but miss out on most of it, the part where it simply goes up.

Even worse, if you look to play pullbacks with stocks that aren’t moving ahead generally like this, the pullback itself isn’t going to be a competitive one even if you end up making a little profit on it. If you make 10% but could have had 30% or more, you have messed up, even if you don’t realize it.

The Majority of the Money is Made with The Main Move, Not with Reversals

Some of these plays do present good enough opportunities, and we’ve brought up a few of them this year, but these tend to be hit and run plays that really aren’t the sort that suit investors or even those who claim to be investors but act more like traders. You might be in a trade like this for few days or even a few weeks but these are special situations, more like scalps, in an asset that is normally well beneath a good play but may offer some good value for a short period of time.

Anytime you hear about someone waiting for a good performing stock to pull back, this tells you that they don’t really know what they are doing. The real problem if you ask them is that they see these stocks as pricey, where Apple was pricey at $200, $250, $300, $400, and the more it goes up the pricier it is in their eyes.

Thinking that stocks could be pricey may be nonsense, but as long as you hold these beliefs this can indeed have you thinking that Apple is pricey now but if it was only a little cheaper then they might be tempted. Sadly, when this day does come, and the call was a good one, and thy later fall, their more fairly priced price now after the fall is going to be a lot higher than when they sat in the past and thought $250 was too much to pay for Apple for some unfathomable reason.

If you like the extra momentum to the upside that pullbacks provide, you should like the additional momentum that these stocks can provide us in other times as well, but you have to get rid of the idea that the value of a stock is something else other than its current price. If Apple was really pricey in reality at $250 or $350, then the market would have not put its price even higher, so the market didn’t think it was pricey at all, in fact it saw it underpriced and jumped in and put the price up.

These people always seem to be looking for a bargain, but don’t realize that the idea here is to buy a stock and sell it higher and that’s where the value lies. When the market is moving ahead, anything that pulls back is not going to tend to be the sort of thing we should be considered, because a cheaper price isn’t a bargain if it goes lower or even if it fails to move up very much compared to what could be had with a better stock.

If you think that price growth is a bad thing, that it makes stocks pricier, and less desirable on account of this, your misunderstanding will indeed cause you to be afraid of good stocks and be more comfortable with mediocre or worse stocks.

This is actually quite a bit worse than investors who just leap on high flyers and hold, because they at least will be in the thing to catch the progress it makes, and while it would be preferable for them to at least consider exiting when things turn sour, these stocks do quite well over time on balance and even doing nothing can provide good returns, like anyone who has bought Apple at any time previous to now and especially those who have been holding it for years.

This is what investors tend to do, they don’t wait to get in on great stocks like Apple because they think they are overpriced and the market disagrees. People wonder how high Apple can go and there are plenty who are already worried about it slowing down, but it will show us when it is ready to slow down and we can decide what to do then.

Looking to play a pullback with a stock that is not pulling back and is doing quite the opposite is a terrible approach, and it’s not even all the money you watch pass you by while you’re waiting, it’s the temptation to use this idea with junk instead and see both the stock and your account balance pull back as your punishment.

We need something extra special to want to be in a stock that is going down while the market goes up, as this is not a pullback that has much potential for positive momentum, as these pullbacks aren’t from delayed momentum to the upside as they don’t have this to start with, it is the expression of negative momentum that we do not even have a good reason to believe will provide any kind of competitive sized move in the other direction, how this stock may do in the period we’re looking to be in it versus what Apple would pay us.

Sometimes stocks beat to a pulp can become great plays, but you really need to know what you are doing to find these diamonds in a pit of rocks. A great example of this would be with Overstock, which pulled back enormously over two years including the coronavirus selloff, but given that this was the perfect stock to be in during a pandemic, like Amazon, once the market starts to move the right way, it became an awe-inspiring exception play. Overstock traded at $2.57 a share at the bottom of this market crash in March, and now trades at $82.40.

That’s what you call a weak stock that had been performing atrociously, being over $80 to start 2018 and falling all the way down to a couple of bucks, but COVID has been very kind to them and they have erased 2 ½ years of massive losses in less than 4 months.

We don’t normally want to be messing around with stocks that go from $89.80 to $2.57 in a little over two years, but this was actually the perfect stock when they locked up all those stores, and people had to start buying a lot more online.

This was one case of a stock having great momentum the wrong way but saw its ship really come in and therefore we don’t want to just be looking at top performers for our pullbacks, and we even recommended Hertz for a short time, and had it as a buy on the day they went bankrupt and this provided a nice treat where people could have quadrupled their money in just a couple of weeks before it was time to go and it quickly gave back almost all of this gain.

You really have to know what you are doing to trade distressed stocks like this, and this is not the sort of thing but all but the sharpest of investors should ever be looking at. These trades require both a lot of skill and care, and if you come up short, you will end up distressed right along with your stock, like those who were crazy enough to buy these on the way down and burn right along with them.

Investors need to keep things simple, and there’s lots of money that can be made with the Apples and Amazons of the world, in addition to all the other stocks that continue to perform well during this financial and health crisis, without ever having to worry about pullbacks and especially ones involving very weak stocks that people love to speculate on.

If people do wish to trade pullback reversals, they need to realize that, at a minimum, we need stocks in general to pull back as well, where the fault needs to be on the market side and not the stock side. If the market is going up, there is no need to even be looking at pullbacks, and if a stock pulls back when the market is moving the other way, that’s the sort of thing that should scare us the most.

It’s just too easy to buy something moving in the direction we want, and stay in it while it is performing well and get out when it starts to pull back too much. Just doing this will put you way ahead of all the talking heads that profess to be providing investors with good investing advice but are instead trying to be traders but don’t even have the basic concepts of trading down yet, and are encumbered with all sorts of crazy ideas such as the view that stocks can somehow be “expensive” independent of what the market thinks.

When they get too expensive for real, that part is easy to tell as well, as their formerly expensive price becomes priced more modestly. Expensive does matter, but we need to know how to tell when stocks actually are, and costing more than before isn’t a bad thing but what we’re actually hoping for.

Hoping for something and being afraid of it and looking to avoid it is never a sensible idea, as this will just twist our minds and our accounts. There’s enough to deal with without our wanting to knot ourselves up this much on purpose. Getting in when something goes up enough and getting out when it goes down enough is a much simpler and much more powerful idea.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

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