Buy The Dip Or Regret Missing It

Buy The Dip Or Regret Missing It

In one of the few red days investors have seen in months, the Big Three major indices were all hammered Thursday as the S&P 500 (SPY), NASDAQ (QQQ), and Dow (DIA) closed down 3.5%, 5%, and 2.7% respectively. As is tradition, all the big financial news websites bombarded us with headlines accompanied with pictures like this:

Source: Markets Insider

So why did this happen? Well, though no catalyst seems obvious, I think most investors would agree this was perhaps inevitable. After all, though big losses are scary and cause panic, when we look at charts for the ETFs tracking these indices, we can see we’ve barely put a dent in the months-long run-up in these funds and the stock market as a whole.

ChartData by YCharts

As this push higher accelerated, I’ve heard many an investor express doubt about “getting in at the top,” as they missed out on green day after green day. I’m sure some of those investors will now be torn — we’re no longer at the top but what if this sell-off picks up steam and turns into a real correction? It’s a fair question! But never fear, for I am here to give you the answer (which is of course my personal opinion)!

First things first, though most headlines are claiming this is the “biggest sell-off since March,” we’ve seen an instance of this same kind of action between March and now. On June 10th, SPY opened at 321.42, and just three trading days later on June 15th it opened at 298. That’s a more than 7% drop! QQQ saw a similar pattern and dropped more than 5%.

Just when bears began to proclaim victory and chide their fellow bulls for investing in such an inflated, unsustainable, V-shaped market, the tide turned just as quickly and on June 16th, SPY opened at 315, clawing back most of the losses of the previous few days (talk about a V-shaped recovery!) We all know the rest of the story, a steady march to all-time highs for the major indices. So buy the dip, right?

This is about the time when some readers will be thinking something along the lines of “but Kumquat Research, past performance isn’t always indicative of future results!” and you’d be absolutely correct. So let’s look at possible reasons why this June recovery might have happened and whether we can expect a similar market reaction this time around.

The Chase For Yield

The primary reason I believe this dip will be short-lived even if it extends for another few days is the same reason we’ve seen such a huge rally: the chase for yield.

As I’m sure you’re all aware, in March the Fed dropped interest rates to near zero, and the general expectation is that this low-rate environment will persist for multiple years at least. At the end of February, the 30-year treasury yield was about 3% and today it closed around 1.35%. The 1-year went from 1.3% to basically 0%. Usually viewed as a risk-free place to park cash and earn a buck or two, holding treasuries is now essentially the same as having a glorified bank account.

And speaking of bank accounts, the average savings account yields a whopping 0.06% APY according to the FDIC, though someday soon, your zero-interest savings account might actually be preferable to a negative yielding treasury bond! But I digress.

Thinking of just holding cash instead? Also no good because the Fed dropping interest rates and injecting trillions into the economy in relief for distressed financial instruments will almost certainly lead to the acceleration of inflation, which Powell and Co. recently stated they would let run hotter than their usual 2% target because it’s been below that target for so many years.

All of this culminates in one question for your average owner of monies: where is the optimal place to invest capital? In the current macro environment, the stock market appears to be not only the best answer but perhaps the only answer.

With stocks like AT&T (T), Altria (MO), Exxon Mobil (XOM), etc. and tons of mutual funds and ETFs all yielding orders of magnitude more than treasuries or other traditional low-risk assets, there’s all the incentive in the world to dive into the stock market in the pursuit of yield. Sure, the whims of the capital markets pose greater risks than a treasury bond might, but there’s a break-even point where the risk-reward profile shifts favorably to the former, and the pandemic has flung us firmly past that point in my opinion.

For those wondering how we could possibly be reaching all-time highs while the economy is in the dump, that is the answer. With the cost of capital plunging and the yields of alternatives to the market along with it, stocks are the new safe haven.

Inflation going up? Stocks! Treasury yields plummeting? Stocks! Got a stimulus check from the government? Stocks! Want a place to put your cash after a big market sell-off? Stocks!

Back in late June, there were reports that assets in money market mutual funds (“MMMF”), which are very low risk and can serve as a proxy for cash held by investors, were at a record almost $5 trillion due to lingering fear and uncertainty over the pandemic. A recent ICI report from 9/2 shows MMMF assets at about $4.5 trillion, indicating some investors decided to move their money elsewhere in the past two months, likely to equities, while an overwhelming majority remain uncertain about the future.

Many of these uncertain cash-holding investors face a difficult choice: buy into an increasingly frothy equity market or continue to eke out measly, albeit virtually risk-free, crumbs from your MMMF’s treasury holdings? When you add the specter of rising inflation this choice only gets more pressing, though perhaps easier. From this perspective, which many investors find themselves, an event like the sell-off in Mid-June that I discussed or Thursday’s steep market sell-off removes some of the previously mentioned equity froth and creates a buying opportunity. This is also important from a mental standpoint as investors are usually afraid to buy at the top, a valid concern considering the red-hot rally since March.

When one considers how much cash is on the sidelines in MMMFs and other low-yielding assets, the rock-bottom cost of capital, and the lack of alternative investments with acceptable yield, a stock rebound becomes less of a question and more of an inevitability. Can I predict the exact day when sentiment will turn around? Alas, I cannot. But the further stocks drop, the more attractive the dip will look to those investors currently sitting on cash worried about inflation and low interest rates.

Investor Takeaway

In my opinion, the current market drop will be short-lived and represents an attractive buying opportunity for the risk-seeking investor. The markets bounced back extremely quickly to the mid-June sell-off for reasons that still exist in the current macroeconomic environment: low interest rates, low cost of capital, the expectation of rising inflation, and excess cash.

With the extremely low yields of alternative assets and the attractive returns offered by the market, stocks offer an asymmetric risk-reward profile that cannot be matched in the current financial landscape. Buying a steep drop in any asset comes with risks, so I’d urge those considering jumping in now to do so with the right mentality (i.e. DO buy stocks you like that dipped 10% and DON’T go all-in with your account on SPY weeklies).

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Thanks for reading!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Originally published on Seeking Alpha

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