Conceived several years ago, "buy the (fucking) dip" was a joke among traders seeking to explain the market's nearly-instant upward mean reversion, which as we have alleged since 2009, has been pushed higher by central bank policy and various HFT strats. Since then it has, sadly, become perhaps the only "explanation" for the behavior of the most bizarre market traders have ever encountered.
Luckily, the buy the dip quote-unquote "market" may be about to end, perhaps as soon as tomorrow, if Bank of America is right.
In a note titled "Reasons to increasingly fear, not love, the dip", BofA analyst Nitin Saksena writes that a "faster US rate hiking cycle jeopardizes the buy-the-dip trade."
His observations will be familiar to anyone who has tried to top-tick the S&P over the past 8 years, to short stocks, or to otherwise do anything besides "buy" (the dip):
Saksena writes that a "buy-the-dip mentality is dominating US equities as Fed put has become self-fulfilling. It has now been 104 trading days since the S&P 500 last fell by more than 1% (on a close-to-close basis), a stretch of calm in US equities not seen since 1995."
Not paraphrasing the Onion, BofA then goes on to say that "this extreme buy-the-dip mentality is helping crush equity volatility, with S&P 3M realized vol now at a meagre 6.6% and in the 3rd percentile since 1928."
What the BofA strategist says next will not make him any friends among the "smart money crowd" whom he accuses of just being mechancial BTFDers, whose only skills are those of videogamers reacting to a sharp move lower which they then promptly buy:
Perversely, US equity sell-offs have seemingly become embraced as alpha (i.e., buy-the-dip) opportunities instead of being feared as bona fide risk-off events, as the central bank put has become a self-fulfilling prophecy. The abnormality of this development is best appreciated through the lens of market volatility, in our view. Chart 9 shows that the speed with which S&P volatility collapses from a state of high stress back to calm has been escalating since the Aug-15 shock, culminating in unprecedented mean reversion during the 2016 US Presidential election.
So what breaks the buy-the-dip trade? According to BofA, the same entity that created it of course: the Federal Reserve.
Given its influence today on equity market dynamics, we think it is critical to understand what could eventually break the buy-the-dip trade and drive more prolonged market shocks.
In our 2017 Outlook, we outlined one scenario that has come sharply into focus recently with the Fed deliberately and rapidly shifting market expectations towards a March hike and investors now debating whether the onset of an old-school pattern of sequential rate hikes may in fact be imminent (Chart 10).
Specifically, we think that if the Fed is handcuffed by its primary mandates of managing employment and inflation (not to mention potential fiscal stimulus and Fed leadership changes), it would no longer have the luxury of being credibly dovish in the midst of the next exogenous shock to markets. This would push the strike of the “Fed put” lower and in turn weaken one of the key supports for the buy-the-dip trade. In other words, a 10% sell-off in the S&P 500 would not alter the reality of stronger – and slow-moving – employment and inflation data, thus constraining the Fed’s capacity to adhere to its adopted “third mandate” of targeting asset volatility.
Positioning is also a key element of our thesis. If cash continues to get pulled off the sidelines as markets rally and US equity positioning becomes sufficiently bullish, we think markets would be further at risk from investors selling rather than buying a dip.
So with as little as 12 hours to go before the Fed kills the BT(F)D trade, what are BofA clients to do? According to BofA, "Equity puts contingent on higher yields attractive to hedge buy-the-dip failure "
Should the buy-the-dip trade become jeopardized as we outline above, equity puts contingent on higher bond yields should be a well-suited hedge that also aligns with our strategists’ bearish view on rates. The nominal cost of equity put protection is already historically low today (e.g., the current premium of an SPX 6M 95% put is in the 3rd percentile over the past 10 years). Moreover, realized correlation between bond yields and US equities, which had fallen to historically negative levels ahead of the US election as yields rose while equities fell, has since rebounded sharply as yields have risen alongside equities (Charts 11 and 12).
So is it over? Is BTFD about to officially become STFR with Janet Yellen's blessing? Tune in tomorrow around 3pm after the initial kneejerk reactions to Yellen's statement and Fed "dots" to find out. And just in case BofA is right, here is the clip that started it all for old time's sake: