How to spot and capitalize on buying the dip during market weakness
This article was adapted from the May 2021 newsletter.
The enormous run up from penny stocks over the past year has come with plenty of ups and downs. Increasing price fluctuations and higher overall volume have made passive portfolio management much more difficult. Investors who both followed the Bowser Game Plan and bought into market weakness were rewarded heavily. To help others buy into future market weakness, we're going to review a simple method for buying the dip.
Defining the Dip
The purpose of buying into market weakness is not to time the markets, but to add exposure to your favorite stocks. Ideally, you want to buy a pullback that is large enough to give you an advantage by buying stocks at a discount. Therefore, major indices must drop at least 10% to qualify as a correction.
Market volatility is a great way to gauge the pullback to make sure that you are not buying too early. We have mentioned using price increases from the Volatility Index (VIX) in the past, and the method still works. In our recent YouTube video, we discussed buying the dip when VIX jumps above $30/share, but that is not a timeless strategy since each year in the stock market is different. If the VIX rises 66% from its recent low or aggressively moves $10 higher, then it’s time to consider buying the dip in the markets. Below is a chart showing these instances over the past year:
Four instances signaled unusually high volatility, three of which occurred during a significant market pullback. The June, September and October spikes all fit the criteria. If you’re unsure as to whether or not the spike is large enough, you can simply multiply the recent low by 1.66. Let’s use the VIX's June low as an example for the calculation:
The VIX exceeded $39.07 in June, meaning that is a sufficient spike to start looking for entry points.
Picking Your Favorites
Not every stock is worth buying on a standard market correction. Investors naturally gravitate toward their losers instead of winners because they are more worried about being right than being profitable. The goal here is to stick to the Bowser Game Plan and get a discount on your favorite stocks – not your biggest losers. The best way to make a list of favorites that you want to buy is to use a simple checklist:
- Is the original story still the same?
- Is it a value or a growth stock?
- Is the stock providing an appealing entry point?
The original story is the reason you initially invested in the stock. An example of a changing story is slowed growth, decreasing value, etc. If it is a value stock, make sure that you are not buying at too high of a valuation relative to its book value. For example, if Stock XYZ has a book value of $2 and only pulled back to $2.50, then you might not want to add more to your position. Lastly, make sure the stock has pulled back enough using the 33% rule.
Before we dive deeper into the 33% rule, we need to make a list of favorite stocks. For the sake of keeping things short and sweet, the list will consist of FlexShopper (FPAY) and Deswell Industries (DSWL). Both of these stocks have the same original investment thesis and fit our criteria. Out of the two stocks, only DSWL is a value investment, so we have to double check its book value before purchasing more shares.
Now that we have identified an appealing dip in the markets and a few of our favorite stocks, it’s time to start buying! The 33% rule, or one-third rule, is simple and there are many variations used by successful investors. The rule states that you can only buy more shares if the stock has retraced 33% of its 52-week range. The 52-week range is the difference between the stock’s 52-week high and 52-week low. After the simple subtraction, just multiply the range by 0.33 to get the distance the stock needs to drop from its high before entering. This is different from just waiting for a 33% pullback because you are factoring in the recent price increase or decrease to avoid overpaying.
We recommended FlexShopper (FPAY) in March 2020 during the COVID-19 crash. The stock bounced back with the stock market in August 2020 just before the September pullback. Since we know that the September dip fits our criteria, we can look to add to this winner. At the time, FPAY had a 52-week range of $2.44 ($3.22 high - $0.78 low). That means that the stock just needs to drop $0.80 ($2.44 * 0.33 = $0.80) from recent highs to justify an entry point. Below is the FPAY chart example:
The entry point for the stock has to be at least $0.80 under its recent high, which means $1.68 was the dip-buying opportunity. Keep in mind that the dip needs to be accompanied by a market downturn, not just underperformance from the individual stock.
DSWL also provided a buying opportunity during the June pullback. The pullback aligned with our recommendation of DSWL in May 2020, giving an ideal entry point for the value stock. Additionally, the stock was trading below its book value. Since, DSWL has run up 70%. If you had used the 33% rule for your initial entry point, you could have added to your position under $2.44 ($0.93 range / 3 = $0.31 required pullback from high) during the June correction.
Risks and Conclusion
The main risk of buying the dip is that the stock will keep on dropping. That is usually going to be the case because nobody can time the markets to perfection. Therefore, you should not be buying full-sized positions on market weakness. Based on your personal preference, 50% (half) or 33% (one-third) of your usual position size is appropriate when accumulating shares. This will help you avoid becoming emotional while leaving more cash on hand for your other favorite stocks.
The other risk of using this strategy is that it may tempt you to go against the Bowser Game Plan. While we do not recommend doing that, you should be fine as long as you do not pay more than $3 for a stock and maintain a diverse portfolio. Adding too much size to one holding puts your portfolio at higher risk.
Overall, the stock market has been a roller coaster over the past year, requiring more active management. If you do not have time to manage your portfolio, then simply set price alerts through your investing platform. Almost all platforms offer this feature and some even send SMS and email notifications. This strategy has been proven to work over the years and is based on math, not emotion. So pick your favorites, wait for a pullback and keep building your wealth!