What to Know If You Want to Buy the Stock Market Dip

Investors have long shared a dream: that the Federal Reserve would always flood the market with cheap money whenever asset prices fell too far.

In 2022, that dream has turned into a nightmare.

With the Fed determined to keep inflation in check, the threat of rate hikes has wiped $10 trillion off the market value of US equities and lowered the price of the worst-yielding bonds since 1842.

You won’t be able to break through this type of market the way you have in the past few years. Buying stocks at a discount, or accumulating stocks when they fall in the belief that they will recover quickly, used to be almost a pleasure; now it will hurt. And forget about getting rich with just a few finger swipes or clicks. Those days are over – although in the end disciplined investors, patience and courage will prevail.

For years, investors believed the Fed would listen to their cries for pain. Think of 2018-19, when the Federal Reserve raised interest rates but then backed out after stocks fell nearly 20% — or early 2020, when the Fed cut rates again and poured cash in. market. Investors celebrated.

Professional investors call this a “put Fed,” a concept that comes from the trading of put options contracts. Owning a trade allows you to sell the underlying asset at a specified price on a certain date. That protects you from any drop below that price until the option expires.

Likewise, when the public believes the Fed is ready to pour cheap money into the market, this helps keep stocks and other assets from falling, creating an over-the-counter put option for investors. private.

Of course, the central bank has no clear policy on backing stocks, bonds, real estate and the like. Former Fed Chairman Ben Bernanke warned that “the impact of such efforts on market sentiment is dangerously unpredictable.”

Federal Reserve Chairman Jerome Powell said on Wednesday the central bank had approved a half-percentage point increase in interest rates in an effort to reduce inflation that is at a four-decade high. Photo: Win McNamee / Getty Images

However, as William Poole, former president of the Federal Reserve Bank of St. Louis, once wrote, “There is a sense that the Fed makes it exist”—namely, that large losses in financial markets could undermine central bank goals. low unemployment and stable prices. Steady economic growth is the end goal, but supportive markets can be an indirect means to that end.

According to Anna Cieslak, a professor of finance at Duke University, between 1994 and 2008, the average 10% drop in stock prices was associated with a Fed rate cut of nearly 1.3 percentage points over the next 12 months. The central bank is more inclined to cut rates during such downturns than investors expected, she said.

Tale of the Tape

Investors face a major test as interest rates rise, inflation accelerates and the Federal Reserve embarks on an aggressive monetary policy tightening campaign.

Weekly federal funds target range *

But with inflation above 8%, an early rate cut would be like trying a flamethrower in an explosives factory.

Ed Yardeni, president of Yardeni Research Inc., an investment strategy consulting firm, said: “The Fed’s recommendation is wrong. “The Fed just can’t respond to the cry of the stock market when inflation is such a big deal.”

Moreover, not even the drastic new Fed could cool down inflation as quickly as it should.

“The idea is that we can create a painless inflation inversion without damaging the real economy,” said Carmen Reinhart, chief economist at the World Bank. “That idea is not based on previous historical experience and I don’t think it’s in the cards.”

There is no modern precedent that suggests the Fed can reduce inflation by at least 4 percentage points without pushing the economy into recession.

Of course anything can happen. If the US dollar continues to appreciate, the cost of imports may drop. Russia may withdraw from Ukraine; Covid-19 may withdraw from China. Oil prices can slide.

But investors should always hope for the best while expecting the worst. Inflation will likely be even hotter and longer lasting than we’ve been accustomed to over the past few decades. That means the Fed, a paper tiger, will have to keep pushing interest rates higher until the cost of living finally comes down.

“It’s time to update the old adage of ‘Don’t go against the Fed’,” Mr Yardeni said. “Now it’s ‘Don’t fight the Fed, especially when they’re fighting inflation.’

With the Fed about to expire, what should you do?

First, avoid long-term bonds and bond funds, which are sensitive to rising interest rates and have lost 20% or more so far this year.

SHARE YOUR THOUGHTS

With the ‘Fed Place Order’ expiring, what changes will you make to your portfolio, if any? Join the conversation below.

Be fully prepared, if you buy at a discount, to let the stock fall deeper and stay at the lower end for longer. Dives can turn into dives, and recovery isn’t always as swift as it was in the last decade.

Put your purchases on autopilot—for example, automatically buy a fixed amount once a month—so you won’t be tempted to give up near the end. In the end, opportunistic buying will pay off, although it may take years.

Rely on assets that can benefit from inflation. The yield on a Series I savings bond, or I bond, will keep pace with (though won’t exceed) the rate of inflation. Some of the Treasury’s inflation-defending securities issues, while not cheap, are now providing a small stepping stone should the cost of living rise even higher. Although stocks have fallen this year, in the long run, they are a good hedge against moderate inflation. A small allocation for goods can also help.

Above all, don’t take great risks to try to catch up. The Fed won’t tape investors’ mistakes anymore.

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Write letter for Jason Zweig at smartinvestor@wsj.com

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Edmund DeMarche

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