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Feb. 10, 2020, 7:00 a.m. EST

Why ‘buy-the-dip’ is the stock market’s default setting — and what it would take for that to change

A supply-chain hit could undercut central-bank backstop

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By William Watts, MarketWatch


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Investors made crystal clear this past week that they aren’t ready to abandon the “buy-the-dip” response to stock market pullbacks, despite warnings that the tried-and-true approach may soon meet its match.

Indeed, one high-profile warning came from Mohamed El-Erian, the chief economic adviser at Allianz and former chief executive at Pimco. He made waves early this week when he warned that China’s coronavirus outbreak could be the catalyst that finally snaps investors out of the buy-the-dip mentality. El-Erian laid out a compelling argument in a Financial Times guest column , warning that the potential for cascading global economic fallout from a prolonged outbreak would challenge the ability of global central banks, many of which have already used up their monetary policy ammo, to provide a backstop.

/zigman2/quotes/210599714/realtime SPX 3,055.73, +11.42, +0.38%

That may prove true. But for now, investor faith in the central bank backstop looks pretty solid.

As worries about the impact of the coronavirus on the global economy rose, triggering a sharp selloff in equities, expectations for a Federal Reserve rate cut later this year rose, according to the fed futures market. Efforts by the People’s Bank of China to provide stimulus and liquidity also served to soothe nerves, triggering a sharp rebound in equities that saw all three major U.S. benchmarks move back into record territory by Thursday.

“I think investors have learned over a very long time that central banks and the Fed, in particular, will be there to save the day,” said Michael Arone, chief investment strategist at State Street Global Advisors, which has $2.8 trillion in assets under management, in an interview.

That’s a mentality that goes back before the financial crisis to at least the 1987 crash, when the notion of a metaphorical “Fed put” began to take hold.

But some market watchers share El-Erian’s doubts about the durability of a “buy-the-dip” framework predicated on central bank largesse. After all, while central-bank efforts are aimed at backstopping demand, the viral outbreak, via its impact on factories and production in China, has implications for the supply side of the economy.

See: Citi’s top strategist is alarmed by rush of clients wanting to buy the dip

In a Thursday note, analysts at Montreal-based Pavilion Global Markets warned that if the spread of the virus isn’t contained, disruptions to supply chains could undermine the outperformance of growth stocks that have been the primary beneficiary of central-bank liquidity efforts.

That’s because the outbreak has forced China to keep several factories closed following the end of the Lunar New Year holiday last weekend. Moreover, Wuhan, and greater Hubei province, is a global manufacturing hub for the tech industry, the Pavilion analysts noted.

That could present a problem for a narrative that’s seen the S&P 500 rally on the back of a narrowing set of growth stocks. “This was justifiable when growth stocks’ earnings were growing,” they said. “Now, the [coronavirus] is impacting the ability of highflying tech stocks to simply produce their wares, much less sell them and grow earnings.”

Read: Coronavirus outbreak is a new risk to U.S. outlook, Fed report says

Stocks had appeared overbought according to technical indicators at the end of January, leaving them vulnerable to a retreat. The coronavirus outbreak offered a catalyst, with equities accelerating a selloff on Jan. 31. But the swiftness of the past week’s rebound took even some bullish market watchers by surprise.

“Normally what you want to see is the market go from overbought to oversold, then you get the sense that all of the selling has taken place” allowing the market to rally anew, said Quincy Krosby, chief market strategist at Prudential Financial, with $1.519 trillion in assets under management, in an interview. “We didn’t get to oversold.”

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