Winter is coming. But is a stock market winter approaching? Nobody knows for sure.
What we do know, however, is that S&P500 (^GSPC +0.31%) Shiller’s (CAPE) price-to-earnings ratio is near its highest level since the peak of the dot-com bubble in the early 2000s.
We know that the Buffett Indicator (the ratio of total market capitalization to US GDP) is at its highest level ever – and well above the level that Buffett warned investors were “playing with fire.”
And we know there’s a good chance the Federal Reserve will raise interest rates again due to stubbornly high inflation.
In this context, stocks could very well fall this winter. If they do, history says that investors who take just one step come out ahead.
Image source: Getty Images. Image source: Getty Images.
The movement that works historically
This move is best known by three words familiar to most investors: “Buy the dip.” Warren Buffett summed up the underlying principle in 13 words: “Be afraid when others are greedy, and be greedy when others are afraid.” »
Buying the dip and being greedy when others are afraid has worked exceptionally well in the past. Since 1950, the S&P 500 has experienced 38 corrections (defined as a decline of 10% or more from the previous high). Guess how many times the index bounced to new record highs. Congratulate yourself if you answered 38.
Buffett practiced what he preached during the 2008 financial crisis. In an opinion piece for The New York Times released when the stock market was down in October of that year, it recognized the factors that were creating anxiety. Buffett then revealed what he was doing in response: “I buy American stocks. »
The legendary investor was referring to what he did personally. However, his Berkshire Hathaway (BRKA -0.01%) (BRKB -0.25%) At the time, I was also stocking up on US stocks, including investing in Goldman Sachs (G.S. -0.36%), Johnson & Johnson (JNJ +1.43%), UnitedHealth Group (UNH -0.40%)And Wells Fargo (W.F.C. -0.43%). Every stock has increased fivefold or more since then.
Applying the approach to today’s market
Should investors today buy all the stocks that are falling if the market experiences a downturn this winter? No. Buying Dip Does Not Mean Buying All on the dive.
Applying the approach that has worked so well historically therefore requires being discerning about what to buy. The smartest strategy is to buy the stocks of companies with strong dominance, pricing power, financial stability and strong long-term growth prospects.
Unsurprisingly, these are exactly the types of stocks Buffett has always preferred. If you look at the stocks Berkshire acquired during periods of market uncertainty, many of them will check each of these boxes.
But Buffett doesn’t think most investors should worry about buying individual stocks. For what? He knows they don’t spend enough time understanding the underlying businesses to be able to accurately predict profit growth. The Oracle of Omaha believes that many investors would be better off purchasing low-cost S&P 500 index funds.
Three essential ingredients
This historically successful approach requires three essential ingredients.
The first is one that investors should start getting immediately if they don’t already have it: cash. Without enough cash, you won’t be able to buy on the dip. By the way, Buffett accumulated a huge stockpile of cash for Berkshire Hathaway before stepping down as CEO at the end of 2025.
The second ingredient is a list of high quality, attractively valued stocks to buy. Above all, you cannot make this list from scratch. Sometimes few actions are suitable. However, during a significant market decline, many opportunities should present themselves.
The third ingredient is the most difficult. Investors need to be disciplined about buying stocks or funds, even if it’s scary. Don’t underestimate the difficulty of being greedy when others are afraid.
Importantly, these three ingredients do not mean that you need to be able to predict how the stock market will move. Even Buffett has repeatedly insisted over the years that he doesn’t know how stocks will perform in the short term. However, he always understood that stocks tend to rise over the long term.
Buying during a downturn was a winning strategy for the multi-billionaire. This can also be a win-win for other investors.
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