Buy the Dip or Sell the Rally?

We are at a crossroads in the stock market. Half of the elite market strategists that I follow are bearish, and half are bullish. What’s an investor to do? Buy the dip, or sell the rally?

Obstacles

The first obstacle we need to overcome is emotional bias. Specifically, fear. The risk of a stock market meltdown has been increasing since the start of 2018, but the data has not yet confirmed it. I’m a data-driven guy, and I count on my models to keep me grounded in reality. What’s reality? Well, it’s not gut feel or emotional reaction. It’s a discipline that requires following a plan and not getting spooked into deviating from it when things get crazy, like they are right now.

The next obstacle is biased thinking. We all have biases in the way we view the world, and we also have biases in the way we view the near-term prospects for the stock market and the economy. These biases take many forms. In today’s environment, political bias is a big one. Do you have faith that our president will navigate the tricky geopolitical landscape and deliver on his pro-growth agenda? Or do you think he’s going to make a serious miscalculation that will backfire and bring down the stock and bond markets?

If you are on either of the two sides described above, you may have a bias problem. If you base your investment decisions on the political drama coming out of Washington, you will likely make mistakes. The economy, and the stock market, don’t care about politics. My view is to try to remain non-partisan as I evaluate the likely course of events over the next 6-12 months. For that, I turn to the numbers that feed my forecasting models.

Trade War risk

Are we about to go down the slippery slope of a prolonged and ever-escalating trade war with China and others? We don’t yet know the answer, but it sure looks like the current administration is hell-bent on picking a fight. Are tariffs justified? Sure. China and others have been taking advantage of US for years. Fighting back makes us feel good, feel tough, feel righteous. But is it good economic policy? I don’t have an answer. But I do know that the stock and bond markets do not like the prospect of a trade war one bit. Trade wars create imbalances in the global economy. They raise the prices of imported goods, some of which Americans have to buy because there is no domestic supplier.

Consumers today are strapped, as they have been ever since the housing bust eliminated the ATM feature of home ownership. And who do you think will pay for the tariffs levied in a trade war? The Gubmint? The retailers? The farmers? China? None of the above. It’s you and I who will foot the bill with higher prices for the things we buy. Can you afford a higher cost of living that could be triggered by a proper trade war? Many simply can’t. So that’s a concern, but not an immediate threat.

Recession risk

There is nothing in the economic numbers that supports the argument that we are headed for a new recession within the next 6 months. With no recession on the horizon, stock market declines are shorter and less severe than they are when accompanied by a recession.

Bear market risk

The probability of a bear market taking hold within the next 12 months is now 21% according to my Bayesian model. That’s concerning, but is it high enough to call for a radical change, such as going to 100% cash or bonds? I don’t think so. Prudence would dictate a slight reduction in equity exposure, but nothing radical.

My proposal

As risk increases, it’s just common sense to dial back on equity exposure. Get yourself to a 20% cash position. If the probability of a bear market or a recession increases sharply, raise more cash. But don’t get scared into thinking that you need to pull the ripcord today. Let your cooler head prevail.

See my article “This Bull Ain’t Dead Yet” here.

And this one “The Death Match Between Dip-buyers and Rally-sellers Intensifies”