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Buffett’s Rule: Buy the Dip – Wild Stock Market Reversal

Written by Leonardo Hadi · 3 min read >
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The stock market has been in volatile trading this week after the fear of inflation spooks the retail and institutional investors. Nasdaq, the leading index for the technology sector, suffered a 360 points loss two days ago on the same day SpaceX landed its SN10 Starship prototype.

However, the stock market displays a strong reversal today as all stock indexes show a major rebound from this week’s dip. Before going into the deep dive of Buffett’s rule for buying the dip, here is the latest performance summary across asset classes today.

Markets

Up/DownMarketPrice/YieldGain/Loss
S&P 5003,841.94+ 1.95% (+73.47)
Dow 3031,496.30+ 1.85% (+572.16)
NASDAQ12,920.15+ 1.55% (+196.68)
VIX24.66– 13.69% (-3.91)
US 2-YR0.14%0 bps
US 10-YR1.56%+ 1.26 bps
OIL66.28+ 3.84% (+2.45)
GOLD1,698.20– 0.15% (12.50)
Bitcoin49,208.31+ 2.32% (+1,154)
As of Market Close on Mar. 5, 2021
Stock Market

The stock market makes a great comeback and shows a wild reversal after a brutal trading week driven by a sharp jump in the volatility index caused by the fear of inflation. The Federal Reserve Chairman, Jerome Powell, signals that inflation is coming, and the statement has caused the stock market to tumble.

However, the strong job growth report has calmed the stock market signaling stronger economic recovery as the non-formal sectors like restaurants and bars. Dow 30 index jumps more than 572 points, followed by NASDAQ by 196 points and S&P 500 by 73 points, while the volatility index drops nearly 14%.

The US Department of Labor announced 379,000 job gain vs. 210,000 jobs expected, which brought the employment rate down to 6.2% from 14% at the pandemic height. The stronger economic recovery benefits the Dow 30 index as it carries more weight in energy and less in non-technology sectors than Nasdaq and S&P 500.

Bond Market

The yield curve’s steepening continues as the spread increases between the short-term (US 2-YR) and the long-term (US 10-YR) treasury bonds. It indicates the return of normal economic conditions and increasing profitability in the financial sector. The bank makes money by borrowing at a lower short-term interest rate and lending at a higher longer-term interest rate.

The yield curve inversion during the pandemic has negatively impacted the performance of the banking sector. The ease of bond yield increase also slowed down the stock market’s panic selling because the rise of bond yield may indicate inflation.

Oil

The oil price continues to rise and hits $66.28/barrel at market close as Canadian oil-sands producers plan to start the plant maintenance. The turnaround activities will cut approximately 500,000 barrels per day to the global oil supply for the next couple of months. The cold snap in Texas and OPEC’s decision not to increase production will contribute to the rise in oil price in the coming months.

Gold

The strong stock market reversal has caused the gold price to drop to $1,698 per oz. Gold price is negatively correlated with the stock market. It means that the rise of the stock market will result in a drop in gold prices. The rise of the gold price is commonly the signal for inflation.

Bitcoin

Unlike Gold, Bitcoin rebounds from the dip and gains more than $1,100 after market close today. The launch of the world’s first Bitcoin ETF increases the liquidity of the cryptocurrency market. It provides more access for the retail investor without the pain of owning a digital wallet, losing a password, or the complexity of the cryptocurrency exchange process.

Buying The Dip: Intrinsic Value

Warren Buffett bought back nearly $25 billion worth of Berkshire Hathaway’s stock during the stock market dip impacted by the pandemic. Even with this large purchase, Buffett still has $138 billion in cash and $271 billion in public company stock holdings. The legendary investor believes that the company’s intrinsic value is higher than the stock price. This condition creates a margin of safety that will protect the investor against any future market downturn.

The intrinsic valuation came from the total of future cash flows that were discounted by the company’s weighted average cost of capital. The stock’s Beta, long-term government bond yield, and debt to equity ratio determined the discount rate. The critical success for calculating a company’s intrinsic value is the ability to accurately predict the future cash flows for the next ten years or more.

The issue comes when the investor overestimates the future cash flow, making the present valuation higher than its true value. Besides, disruptive innovation, macroeconomics, and consumer behavior shift that will impact the future cash flow are difficult to predict. Therefore, it is critical to be conservative in making assumptions about the future.

Intrinsic value is the most critical information to decide if buying into the dip is a good decision or not. The investor will not be able to profit from the dip without knowing the stock’s true value.

For example, if an investor determines that Apple’s intrinsic value is $150 per share and the stock price is $120 per share, it means that there is a $30 per share margin of safety. When the economic condition recovers, Apple’s stock will likely return to its intrinsic value of $150 per share, and the investor will make a $30 per-share profit.

However, when the dire economic condition returns, the stock will not likely drop below $120 per share, which will protect the investor from a loss. But, the real challenge is whether $150 per share is the actual intrinsic value of Apple. If it is not, then the stock may go further beyond the market of safety, and the investor will suffer a severe loss.

Therefore, when evaluating an intrinsic value, the key strategy is:

“It is better to be approximately right than precisely wrong.”

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Written by Leonardo Hadi
MBA from the University of Illinois at Urbana-Champaign. Quantitative Fund Investor. Professional Engineer. Operations Professional. Profile

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