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Feb. 25, 2020, 10:55 a.m. EST

Buffett is bullish on stocks but says the market can drop 50% — is he wrong?

Amid a 10-year-plus bull market, many investors can’t come to terms with the idea that there could be a substantial decline in the stock market

By Nigam Arora


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Warren Buffett: “ Anything can happen to stock prices tomorrow.”

Stock market investors are watching the coronavirus spreading far beyond China.

It is no longer mostly in Asia. Italy has reported six coronavirus deaths and an accelerating number of cases. At a time like this, it is nice to see Berkshire Hathaway’s (NYS:BRK.B)  Warren Buffett assuage investors. Buffett‘s advice — don’t buy or sell on the headlines — is especially applicable now.

There is a gem in Buffett’s annual letter , which was released over the weekend, that nobody is talking about. He writes: “ Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater.” He continues that the combination of what he calls “The American Tailwind” and “compounding wonders” will make equities “the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!”

Let’s explore this issue with the help of a chart.

Chart

Please click here for an annotated chart of the Dow Jones Industrial Average ETF (PSE:DIA) , which tracks the Dow (DOW:DJIA) .

Note the following:

• Take a close look at the scale on the right side of the chart to fully visualize how far this stock market has come since the point marked as an Arora buy signal in March 2009.

• The stock market bull is now over 10 years old. Investors are suffering from a recency bias. Please see “This 25-year stock market chart shows investors are under a spell of bullishness.”

• Many investors simply cannot come to terms with the idea that there can be a substantial pullback in the stock market. Buffett is clearly aware of, and accepting, of such a scenario. There is a probability of 25% of a major pullback. No one rings the bell at the top. Before you send me hate mail, keep in mind that immediately after Donald Trump’s election, The Arora Report gave a buy signal at a time when most analysts were predicting a big fall in the market. Shortly thereafter, I called for Dow 30,000. Please see “Here’s the case for Dow 30,000 in Trump’s first term.” The Arora Report also gave a buy signal in March 2009, which turned out to be the start of this bull market.

Ask Arora: Nigam Arora answers your questions about investing in stocks, ETFs, bonds, gold and silver, oil and currencies. Have a question? Send it to Nigam Arora.

• If the market goes down, it will not do so in a straight line. Investors ought to pay attention to the support zones shown on the chart.

• The first support zone shown on the chart is the zone of recent congestion before the latest breakout in the stock market.

• The second support zone shown on the chart is around the low point in December 2018 when the stock market had fallen about 20%. The chart shows the Arora buy signal on Christmas Eve 2018, which turned out to be the low.

• The third support zone shown on the chart is around the zone from where the stock market took off after Trump’s election.

• Semiconductor stocks have been the leaders on the upside. Consider watching stocks such as AMD (NAS:AMD) , Micron Technology (NAS:MU)  and Nvidia (NAS:NVDA) for clues.

• Apple (NAS:AAPL) has major exposure to China. Watch for a decisive break of the $300 level.

• Investors have been hiding in large-cap tech stocks such as Amazon (NAS:AMZN) , Microsoft (NAS:MSFT)  and Facebook (NAS:FB) . Consider watching these stocks to see if they break their support levels. Please see “Stock market generals are marching ahead, but the troops aren’t following.”

• The move up in gold has been very strong since the recent breakout. Consider watching gold ETF SPDR Gold Shares (PSE:GLD) , silver ETF iShares Silver Trust (PSE:SLV) and gold miner ETF VanEck Vectors Gold Miners ETF (PSE:GDX) . Please see “Gold breakout’s while the stock market is rising should concern investors.”

• The chart shows the Arora signal to start a short-term trade to buy inverse leveraged Nasdaq 100 ETF (NAS:SQQQ) and for those who can short-sell, to do so using Nasdaq 100 ETF (NAS:QQQ) . An inverse ETF goes up when the stock market goes down.

Down the elevator

There is an old saying that stocks go up the stairs but come down the elevator. A big, quick drop in the stock market is not unusual, although investors who have gotten used to recently overly bullish behavior in the market may not remember the true nature of the stock market.

Long term and short term

Investors can increase their returns and lower their risks by diversifying their portfolios among time frames. That way, if investments do not work out in one time frame, they tend to work out in a different time frame.

Complacency

Even as coronavirus fears are spreading across the stock market, investors are still too complacent. Greed is still overwhelming fear. Please see “Extreme greed in the stock market is producing a bad setup as earnings season starts.”

Many investors simply do not believe that the stock market can go down with the Federal Reserve willing to do whatever it takes to prop up the stock market. Please see “Stock market investors’ motto — ‘in central banks we trust’ — is still working.” Even among those who accept that the stock market can fall, many believe any downturn will be short-lived and the best way is to ride it out.

I have been a student of the stock market and an investor for over three decades. My observation is that what investors plan and say when the stock market trend is still up is very different from what investors do when the stock market falls. It is best to protect long-term portfolios with cash and hedges in a judicious manner. As the chart shows, The Arora Report’s long-term portfolios are up to 57% protected.

Investors ought to pay attention to the fact that even Warren Buffett uses the verb “will” to describe drops in the stock market of 50% or even greater in his carefully written letter.

Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. <INTERNAL-PAGE URL="/author/nigam-arora">Nigam Arora</INTERNAL-PAGE> is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.

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