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

Investors have long shared a dream: that the Federal Reserve will always flood the markets with cheap money whenever asset prices fall too far.

In 2022, that dream has turned to a nightmare.

With the Fed determined to stifle inflation, the threat of rising interest rates has knocked $10 trillion off the market value of U.S. stocks and hammered bonds with the worst returns since 1842.

You won’t be able to get through this kind of market the way you did the past few years. Buying the dips, or amassing stocks as they drop in the faith that they’ll quickly recover, used to be almost a delight; now it’s going to hurt. And forget about getting rich with a couple swipes of a finger or clicks of a mouse. Those days are gone—although investors with discipline, patience and courage will still prevail in the end.

For years, investors have believed the Fed would listen to their cries of pain. Think of 2018-19, when the Federal Reserve raised rates but then retreated after stocks fell almost 20%—or early 2020, when the Fed slashed interest rates again and infused the markets with cash. Investors celebrated.

Professional investors call this the “Fed put,” a notion derived from trading in put-option contracts. Owning a put enables you to sell the underlying asset for a specified price by a given date. That shields you from any declines below that price until the option expires.

Likewise, when the public believes the Fed stands ready to pour cheap money into the markets, that keeps stocks and other assets from collapsing in price, effectively creating a free put option for investors.

Of course, the central bank doesn’t have an explicit policy of propping up stocks, bonds, real estate and the like. Former Fed Chair Ben Bernanke has warned that “the effects of such attempts on market psychology are dangerously unpredictable.”

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

However, as William Poole, ex-president of the Federal Reserve Bank of St. Louis, once wrote, “There is a sense in which a Fed put does exist”—namely, that big losses in financial markets can undermine the central bank’s objectives of low unemployment and stable prices. Steady economic growth is the end, but supporting markets can be an indirect means to that end.

From 1994 through 2008, a 10% fall in stock prices, on average, was associated with rate cuts by the Fed of nearly 1.3 percentage points over the next 12 months, according to Anna Cieslak, a finance professor at Duke University. The central bank has tended to cut rates in such downturns by more than investors expected, she says.

Tale of the Tape

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

S&P 500 Index

Weekly Federal Funds Target Range*

But with inflation above 8%, cutting interest rates anytime soon would be like testing a flamethrower in a dynamite factory.

“The Fed put is kaput,” says Ed Yardeni, president of Yardeni Research Inc., a firm that advises on investment strategy. “The Fed can’t possibly respond to the cries of the stock market when inflation is such a big problem.”

What’s more, even the newly aggressive Fed isn’t likely to be able to cool inflation down as quickly as it wishes.

“The idea is that we can engineer a painless reversal in inflation without sustaining damage to the real economy,” says Carmen Reinhart, chief economist at the World Bank. “That idea is not based on prior historical experience, and I don’t think it’s in the cards.”

There’s no modern precedent suggesting the Fed can lower inflation by at least 4 percentage points without knocking the economy into recession.

Anything can happen, of course. If the U.S. dollar continues to surge in value, the cost of imports could fall. Russia might retreat from Ukraine; Covid-19 might retreat from China. Oil prices could slide.

But investors should always hope for the best while expecting the worst. Inflation is likely to run hotter and last longer than the past few decades have accustomed us to. That means the Fed, long a paper tiger, will have to keep pushing rates higher until the cost of living finally backs down.

“It’s time for an update to that old adage, ‘Don’t fight the Fed,’” says Mr. Yardeni. “Now it’s ‘Don’t fight the Fed, especially when they’re fighting inflation.’”

With the Fed put expiring, what should you do?

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

SHARE YOUR THOUGHTS

With the ‘Fed put’ expiring, what changes are you making to your portfolio, if any? Join the conversation below.

Be fully prepared, if you buy the dips, for stocks to drop farther and stay down longer. Dips can turn into dives, and recoveries won’t always be as swift as they’ve been in the past decade.

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

Lean toward assets that can benefit from inflation. Returns on Series I savings bonds, or I bonds, will keep pace with (although won’t exceed) the rate of inflation. Several issues of Treasury inflation-protected securities, while not cheap, currently provide a small cushion if the cost of living shoots even higher. Although stocks have been pounded this year, in the long run they are a decent hedge against moderate inflation. A small allocation to commodities might also help.

Above all, don’t take big risks to try catching up. The Fed isn’t going to bandage investors’ mistakes anymore.

More from The Intelligent Investor

Write to Jason Zweig at intelligentinvestor@wsj.com

Copyright ©2022 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8