Before You Buy the Dip, Read This…

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I was enjoying a cocktail on my neighbor’s porch early Saturday night when the skies suddenly changed.

Thunder rolled in as the horizon turned an ominous shade of purple and the wind began bending the treetops. We retreated inside just a few moments later as the first raindrops fell and watched the storm unfold from the safety of the kitchen.

It was gone almost as quickly as it appeared – but the powerful storm left plenty of damage in its wake. Residents reported power outages, more than 400 downed trees, and 170 blocked roadways throughout the city.

Aside from a few short power outages, my neighborhood was spared. The only evidence in the yard were a few stray sticks and branches, which we cleaned up on Sunday afternoon before I sat down at my desk to survey the markets and prepare for the new trading week…

As you might imagine, I couldn’t help but think the universe was toying with me when I saw the market begin to unravel in Japan and spread through crypto and the futures market.

Stocks were in freefall – no doubt about that.

But how long would the storm last?

Before we attempt to answer this question, let’s take a minute to review how it all went down…

Japan found itself in meltdown mode as the Yen carry trade imploded and global recession fears spread. The Nikkei fell more than 12% on Monday, which the WSJ notes is its biggest drop since the 1987 crash [Editor’s note: If you’re interested in learning more about the Yen carry trade, check out Sean’s Monday writeup].

Of course, the selling didn’t stop there. The bloodshed in the Asian markets spread into crypto, which spilled over to US equities by the early morning hours. We were already seeing some small pockets of worry crop up late last week, which began to snowball early Monday morning. You always know the market is making waves when non-financial types are posting about the carnage on social media – and the panic was certainly palpable Monday morning.

The market was dumping and the VIX spiked to levels not seen since the Covid crash. The bell rang – and investors started selling.

These are the days that put traders and investors to the test. How you react to major selloffs can affect your portfolio for months to come. If you aren’t prepared and you begin to make panicked decisions, you can cause serious damage to your returns.

In “meltdown” situations, the survivors will be those who can remain calm and focused when everyone else is running around with their hair on fire.

While I can’t yet tell you how the averages will look at the end of the week, we can discuss what to expect in a higher volatility environment like the one we’re entering right now – and how you should adjust your trading strategy as stocks sail into rough waters.

1. When Investors are Scared, Cash is King

Even in bullish conditions, the market rarely cares about any of the amazing stories about your favorite investments. You can’t argue fundamentals or growth stories in a crashing market. If panic conditions emerge, investors only want cash. They crave safety above everything else.

Crypto is the perfect example of this phenomenon. I know there are plenty of folks who argue that Bitcoin is a safe haven investment. But the market says otherwise! Crypto actually trades like a risk asset. That’s why we watched Bitcoin get smashed into the low $50K range late Sunday as more than a few crypto traders were liquidated. When the margin call comes, the only way to pay is cold, hard cash!

If investors are raising cash, they will sell anything and everything, even gold. You might remember that gold even dropped a staggering 25% during the throes of the Aug. – Oct. 2008 meltdown. Keep in mind, this was in the middle of a huge bull cycle for gold, which was unceremoniously interrupted by the Lehman Brothers bankruptcy and the ensuing financial crisis.

Investors will also sell their big winners during these times of distress. The VanEck Semiconductor ETF (SMH) has tumbled nearly 30% from its July highs. The Nasdaq 100 is down 15% over the same timeframe.

Yes, even the bulletproof Magnificent Seven stocks are collectively more than 20% off their all-time highs.

2. Stocks “Hold Hands” During Down Markets

The market becomes highly correlated during drawdowns and panic events.

What does this mean?

Simply put, on the big, sweeping down days and crashes, most groups and asset classes react with similar moves.

Correlations are lower during bull markets. You’ll have big winners, middling names, and laggards. Think about how the market was acting earlier this year. We have semiconductor stocks leading the market by a mile, many tech names also cruising higher (just not as much), while other sectors lagged.

That doesn’t happen during sustained drawdowns. When everyone is fighting for the exits, very few areas are safe from the sellers. And I’d venture to guess that most of the visible stocks will be down about the same as the averages during these dumps, with some of the higher-flying names from the past few months taking some bigger hits.

When sentiment sours and investors become more cautious and defensive, it’s that much more difficult for individual groups to outperform.

3. Respect the Swings

When markets suddenly get squirrely, you probably experience a strong urge to do something, anything, to right the ship.

But part of investing or trading is simply surviving. After all, you have to preserve your capital if you want to stay in the game! And since we just experienced a severe volatility spike, it’s important to remember that we’re probably going to see strong moves both higher and lower in this new environment.

Volatility can be your best friend or your worst enemy. If you’re a longer-term investor, you have a great opportunity to start nibbling at some of your favorite companies (If you liked it at $70, you’ll love it at $50, right?)

If you’re a trader, you’ll want to look to compress your timeframes. Yes, you can take advantage of the bigger swings. But you’ll want to take profits when you can, because the market’s more likely to experience back-and-forth action. Take what you can get, then move on!

As for finding the absolute bottom following a market downturn, don’t forget what legendary technician Walter Deemer says: “When the time comes to buy, you won’t want to.”

The post Before You Buy the Dip, Read This… appeared first on Daily Reckoning.

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