When the Dip Turns to a Waterfall

Individual investors are relentlessly “buying the dip,” yet stocks continue to tumble. Maybe it’s time to abandon the risky bets and get into something real?

Key Takeaways:

In the midst of a ruthless bear market, individual investors are setting buying records. Is it time to give up last year’s strategies?
Right now, the Fed is sacrificing the stock and bond markets for the sake of lower inflation. Do they have the guts to continue?
A decade of free money and stock market strength have convinced investors that stocks are effectively risk-free. This is a false, and dangerous, proposition.

Down Goes Everything

Let’s see how the stock indices and other asset classes are faring in 2022.

The S&P 500 is down 18%.

The Dow Jones Industrial Average is down 14%.

The technology-heavy NASDAQ 100 is down 28%.

Bond prices are down 10%, which means bond yields are surging.

Bitcoin is down 37%.

Gold is up 3.5%. For the last couple months, gold’s performance has been lackluster.

This is to be expected during market crashes. Investors are in “sell everything” mode. When traders get margin calls on their speculative bets, they often sell whatever they have left to sell. If you received a margin call on your Netflix stock right now, would you sell at a 75% loss? Or, would you cover your commitments by selling the position that has only dropped a couple of percentage points?

The U.S. dollar is up 9%.

Despite record-high inflation in the U.S. (which would normally hurt the currency), the Federal Reserve’s aggressive tightening is boosting the dollar’s strength against other currencies. The Japanese yen has fallen to a 20-year low against the dollar. The Ukraine conflict is putting heavy pressure on European currencies such as the euro, Swiss franc, British pound, and Swedish krona.

Now this is a tough scene of epic proportions. If you are anything but a gold investor, you’ve had a tough year.

Flip Flop Fed

The question is, will the Fed have the guts to continue tightening monetary policy? Markets are addicted to the Fed’s free money, and continuing to withhold it could inflict further damage.

In 2020 and 2021, markets reached nose-bleed valuations on the assumption that the Fed would perpetually pump money into the system. Then, inflation came in and ruined the party. Jerome Powell now has a key decision to make. Will he continue sacrificing stocks and bonds for the sake of lower inflation? Or, will he pivot toward more dovish policy and try to mitigate damage?

If he chooses the latter, the Fed’s credibility would be crushed. When central bankers lose the public’s trust, they tend to pour into the one asset that serves as insurance against central banking: gold.

Buy the Dip?

Many investors today have never experienced a bear market in equities. Sure, the S&P 500 dropped 35% at the onset of COVID-19, but the market ended up rallying back to an all-time high within a few months. When today’s investors look back at stock market history, the winning strategy is obvious: just buy the dip!

Unfortunately, it’s not that simple. What happens when the dip becomes a waterfall?

Last Thursday, the downsides of a “buy the dip” strategy were on full display. According to Vanda Research, individual investors set a one-day buying record. Those that bought the S&P 500 last Thursday are already down 5-7%. Individual investors also set monthly buying records in March and April.

This is characteristic of bear markets. Often the largest up days occur in the middle of secular downtrends. Investors who buy in bear markets should be aware that their break-even point may be years away, not months.

The Importance of a Hedge

There is a dangerous assumption hidden inside the “buy the dip” strategy: the assumption that stocks are risk-free. Everyone knows in theory that stocks go down, in the same way that a first-time triathlete knows in theory the difficulty of an Ironman. But until you get in the race and feel the pain up close, “difficult” really means nothing. It’s not until you actually watch your stock portfolio drop 60% that you understand why people fear the markets.

When you look at a chart of the S&P 500 over the last 150 years, stocks do, in fact, look risk-free.

But, embedded inside the upward trendline are extended periods of extreme financial hardship, during which shares of the world’s greatest companies fell nearly 100%, when debilitating inflation chewed up gains, and when “buy the dip” was really, really bad advice.

Trying to time the bottom of a market is futile. A much better strategy for individual investors is diversification. A strong gold position prepares your portfolio for when central bankers fail, when speculation goes sour, and when the dip becomes a waterfall.

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As always, thank you so much for reading – and happy investing!