Key Points:

1. Driven by passive capital flows and the Federal Reserve's guarantee of a safety net, retail investors see declines as opportunities, but this belief relies on market stability and central bank intervention. Once external shocks strike and structural instability occurs, buying on dips will become ineffective and exacerbate risks.

2. Continued inflows into passive ETFs and index funds have intensified the market capitalization of large-cap stocks, pushing market concentration to its highest level since the dot-com bubble. This has weakened price discovery and masked potential vulnerabilities amidst declining volatility.

3. Investors do not have to exit the market, but they need to operate with "guardrails": maintain cash reserves, prioritize companies with sound fundamentals, use hedging tools to reduce tail risks, avoid high leverage, and realize profits in a timely manner during high valuation stages to cope with potential reversals.

ETF fund flows this year are a prime example of this. Retail investors almost instinctively view sell-offs as opportunities, interpreting every dip as an entry point. In stark contrast, institutional investors are more likely to hold onto their holdings, add hedges, and patiently await confirmation signals.

Changes in capital flows are also clearly visible. Current retail investor enthusiasm is often influenced by market momentum and information on social media platforms like Reddit and TikTok. Passive indices are also slowly changing market logic. We can see that the objective influence of automatic capital inflows is building trends: if a stock price falls while capital continues to flow in, the impact of the stock price falling back to its previous level can be quickly reversed. Nvidia is a prime example. This phenomenon further reinforces retail investors' belief that "every decline will eventually rebound!"

But we should also know that such an assumption is fraught with risks.

Michael Green once described the current market as a "mindless robot," with index funds and other passive instruments currently dominating the market with mechanical buying behavior, oblivious to valuations. Jesse Livermore made a similar point in his book "The Speculative Method": Passive funds tracking market-capitalization-weighted indices buy more as prices rise, while fundamentals are largely ignored. This has driven the market capitalizations of large companies to inflate. The top ten companies in the S&P 500 now account for over 38% of the market capitalization, a concentration comparable to that during the dot-com bubble.

Consequently, the relentless upward trend fostered a "buy the dip" mentality among retail investors. The continued strength of large-cap stocks created the illusion of an unbreakable trend, attracting more funds to passive ETFs. This was complemented by retail investors increasing their exposure to options and short-term speculation. Overall, this feedback loop between passive buying and retail speculation boosted the market, but also created a disconnect between valuations and reality.

As volatility declines, the market's apparent resilience masks greater fragility. If external shocks occur, the feedback loop could reverse and amplify risks. Trump's tariff storm in April of this year is a typical example.

The History and Current Concerns of “Buy the Dip”

"Buying the dip" is not a new strategy. In 1999, retail investors flocked to tech stocks every time they fell by more than 5%. While this strategy proved effective in the short term, it's not guaranteed. For example, investors suffered heavy losses during the dot-com bubble burst. During the 2008 financial crisis, Warren Buffett urged investors to "buy American," a message that ultimately proved correct. However, many investors who jumped in prematurely suffered losses exceeding 30% before the market bottomed out in March 2009. Therefore, buying the dip only offers a degree of safety when the market is structurally stable. However, during periods of market instability, declines can easily escalate into precipitous declines, making buying the dip ineffective.

Retail investors often overlook this point. They tend to view market fluctuations and adjustments as short-term opportunities, thus ignoring risk signals and chasing momentum while neglecting valuations and the macro environment. Since the financial crisis, valuation fluctuations have widened, and the gaps between small-cap and large-cap stocks, value and growth, and international and domestic stocks have become increasingly pronounced. The root cause lies in the frequent occurrence of zero interest rates and central bank intervention, which has created so-called "moral hazard."

"Moral hazard" refers to the fact that even if people could avoid risk, they lack the incentive to do so due to insurance or external protection. In the investment context, retail investors generally believe that the Federal Reserve will "cover the bottom" in times of crisis, providing them with implicit insurance. Consequently, they are willing to leverage the riskiest assets and continuously buy at the bottom.

The danger of this assumption is that passive capital flows and central bank intervention are neither continuous nor timely. At the beginning of the 2020 pandemic, ETFs traded significantly below their net asset value, disrupting price discovery until the Federal Reserve again bailed out the market. This bailout, while primarily aimed at stabilizing the overall structure, further weakened market efficiency, effectively creating an interventionist approach. Research shows that as the proportion of passive capital increases, correlations between unrelated stocks increase significantly, further integrating the market. Declining stock prices and repeated central bank bailouts have impacted the free market's pricing system.

In a bull market, vulnerabilities are masked. However, when market liquidity tightens and external shocks occur, risks rapidly magnify. Ironically, it is retail investors who are currently driving flows, reinforcing a "buy the dip" cycle. However, this cycle is premised on continued passive capital inflows and central bank support—unsustainable in the long term.

What will happen to the markets if the Fed is unable or unwilling to intervene in the next crisis?

The Fed 's Choice

If the Fed doesn't intervene again, the market could be impacted from multiple perspectives. First, unexpected events could force passive funds to sell en masse, disrupting the market inertia that has built up over the past decade. Second, macroeconomic shocks persist: credit tightening, geopolitical escalation, or an economic recession could dry up capital inflows. Third, if large tech companies' earnings fall short of expectations or if they revise down their guidance, confidence in the market's dominant heavyweights would be directly undermined. Finally, if interest rates or inflation unexpectedly rise, raising financing costs and forcing the unwinding of leverage, the chain reaction of deleveraging could amplify market declines.

History shows that when valuations are pushed to extreme levels and leverage rises sharply, a catalyst for mean reversion is minimal. Valuations not only directly trigger market peaks but also provide directional guidance for forecasting the extent of subsequent declines. US market valuations are currently at historically high levels, and comprehensive valuation indicators have recently reached new records. This does not bode well for long-term bulls.

If this scenario plays out, retail investors will be the first to suffer. This is because the current buying on the dip assumes a solid market structure and a backstop from the Federal Reserve. But if this structure falters, unprotected retail investors will often be the first to suffer.

This raises a more practical question: How should investors respond now? The answer isn't to exit the market completely, but rather to remain involved, albeit selectively and with guardrails. Maintaining a certain level of cash reserves is crucial; rather than being a burden during periods of heightened volatility, it provides flexibility and optionality. Focus on high-quality companies with strong fundamentals—those with healthy balance sheets, stable cash flows, and consistent dividends—to provide a buffer in an uncertain environment. Tactical hedging tools are also essential, such as inverse ETFs or put options, which can offset some risk during market declines.

Another key point is to avoid high leverage. Over the past fifteen years, with zero interest rates and the Federal Reserve's protection, leveraged investing seemed unstoppable. However, if the environment changes, leverage will only amplify risk. Diversification is also crucial. Combining passive investing with active management, balancing growth with value, and moderately introducing alternative investments can all reduce concentration risk. Most importantly, investors should be willing to realize gains when valuations are significantly stretched. Cash is also a position, especially at transition points in the cycle.

Markets operate in cycles. Over the past 15 years, zero interest rates, central bank support, and passive capital inflows have provided the fertile ground for a recurring "buy the dip" strategy. But if the world changes and investors cling to the old logic, the odds are stacked against them not a new recovery but a deeper recession.

Will the “Federal Reserve Call Option” always work?