For many years the owners and employees of Strategis Financial Group have operated with the belief that buy and hold is not a viable investment strategy–especially for retired investors. Throughout most of the 1990s it often seemed that we were a lone voice crying in the wilderness. Even during and after the market correction of 2000-2002, most investors and traders appeared to believe that the bull market would soon resume and losses would be quickly recouped.

Now we find ourselves in 2009 and major market indices have declined to levels last seen in 1997 or 1998. Many investors have suffered huge losses. Retired investors who have seen accounts decline 50% or more are realizing that they probably won’t live long enough to make back what they have lost.

Today we are no longer the only voice saying that buy and hold as an investment strategy might no longer make sense. Below are a few recent comments about buy and hold as an investment strategy. There were dozens more I could have included and anyone could find similar examples with a simple Internet search.

Peter Bernstein, a respected economist, wrote this in an op-ed piece in the Financial Times: “The cold statistics have hardly been encouraging for the traditional [buy and hold] view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts.”Or consider this comment from Ben Stein, an economist, author and actor: “Buy and hold as a strategy is very questionable…. It’s worked in the past, but in times of severe market stress it just doesn’t work.”

“The Citi case study, however, has an upside; it has led to the death of buy-and-hold investing, which is ultimately a good thing in that the public can now see that vested interests of a relatively small group of Wall Street connected insiders, acting without full transparency, some might say deceptively, can be ripped apart by free market patriots from Main Street,” said Bill Cara, author of a market blog and president of Cara Trading Advisors Bahama.

“The five stages of death are denial, anger, bargaining, depression and finally, acceptance. We bring it up, because right now, Wall Street is really struggling with that last one, acceptance. We’re talking about the death of that time honored investment strategy, buy-and-hold. Investors just can’t let go, and they need to,” stated a CNBC Rapid Recap report.

A Reuters report said, “Every bull market produces its fair share of investment myths and financial fads. During the … 1920s, buying equities with high levels of margin debt was the norm among everyday investors. In the mega bull market from 1982-2000, it was the notion of buying and holding index funds at all times that became the cornerstone strategy for many institutional and small investors alike. There is one problem: both strategies led investors off a financial cliff!”

The last quote is interesting because it came from a study that compared buy-and-hold investing with two very simple active management investment strategies: a 200-day moving average and a January barometer. The study covered the years from 1987 to 2008 and over that time period, both active strategies far outperformed buy and hold.

One problem is that many former advocates of a buy-and-hold system have no viable alternative to offer investors during the current severe market downturn. That means they don’t know when to buy into the market or when to sell.

After two weeks of watching major indices stage a sharp rally, many investors are wondering if this is a good time to be re-entering the stock market. As we explained a couple of weeks ago, the current move still appears to be a bear market rally and as such, the risk of jumping into the market at this point is very high.

The chart below shows price movements of the Dow over the past couple of years. The gold line on the chart is a 200-day moving average–one of the strategies mentioned above that has far outperformed buy and hold over the past 20 years. As mentioned above, this is a very simple, unsophisticated strategy. But it is very good at identifying major trend changes.

Notice that using the 200-day moving average, an investor would have sold out of the Dow near the end of 2007–very close to the top. And although the Dow has risen sharply over the past couple of weeks, it is still 1,500 points away from its 200-day moving average. Until it approaches that point, there is little reason to believe that the current move is part of a change in the long-term trend and not just a bear market rally.

The red line is simply a trend line to show that the current rally is still within the parameters of what one would expect for a bear market rally. The bottom portion of the chart is a moving average convergence divergence (MACD). I like this indicator because it does a good job of identifying extremes in market momentum. Right now it is showing that the current move is becoming overbought and we could soon see another downturn. And as we have already witnessed, the intermediate down moves during a bear market can be especially sharp and severe. That is why we believe that the risk of reinvesting at this time outweighs the potential for reward.
F.S.

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I have mentioned in the past some of the challenges I faced over the past year as I tried to keep a flock of chickens. From the beginning, I knew that some losses would be inevitable. My primary reason for having chickens is to help control insects in my yard and pasture. That necessitates allowing them to roam freely, making them vulnerable to foxes, neighborhood dogs, and other predators.

As anticipated, I lost a couple of chickens each month all through the summer. By October, I was down to three hens and a tough old rooster. These surviving birds knew to fly up into the loft of the barn when there was danger, so I figured they would make it through until spring.

In February 2009, the remaining chickens attracted the attention of an old, wise raccoon. At first he was content to steal some eggs and I was willing to look the other way. Then in a period of about a week, he killed my last four chickens. By then he had also become familiar with my barn. Once the chickens were gone, he started eating cat food, and then rolled oats and corn used to feed the horses. In the process, he would knock over the buckets and spill a lot of grain onto the ground, causing it to be wasted.  His destructive behavior became a nightly occurrence that I could no longer afford to overlook.

I spent money on traps and devoted several mornings and evenings to trying to catch the raccoon. He eventually succumbed to a trap placed inside a bucket of grain.

There are many lessons about risk that one can learn from this situation. By becoming too greedy, the raccoon increased his personal risk. If he had controlled his appetite, he could have continued indefinitely stealing eggs and an occasional chicken.

I erroneously believed that my risk (and investment) ended with the chickens. It never occurred to me that the chickens could expose me to additional risk by attracting nuisances that would cause havoc in other areas of my barnyard.

The chickens did what I expected when it came to controlling insects and I am already raising a new batch of chicks. But now I have a much better knowledge of the type of effort I need to make to help protect them and to prevent ancillary problems.

Jeremy Grantham is the Chairman of the Board of Grantham Mayo Van Otterloo (GMO) a global investment management firm well known among institutional investors. Grantham began warning investors about a global credit implosion in 2006. More recently he described the circumstances that led to the current economic situation not as a housing bubble or a financial bubble, but as a risk bubble.

Grantham was among many experts who warned about impending problems in real estate or in the credit markets. Their warnings were generally ignored and key people who could do something to prevent the problems failed to anticipate how those difficulties would eventually impact virtually every facet of the global economy.

In a quarterly newsletter to clients in Fall 2008, Grantham commented on the underlying causes of the world credit crisis:

“I ask myself, ‘Why is it that several dozen people saw this crisis coming for years?’ I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke — none of them seemed to see it coming.

“I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained — but we end up with an army of left-brained immediate doers.

“So it’s more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored. . . .

“So we kept putting organization people — people who can influence and persuade and cajole — into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don’t have those skills.” 

Over the past couple of weeks we’ve seen the major stock indices rebound strongly. In last week’s newsletter I wrote about bear market rallies and the danger they present by pulling investors back into the market only to begin another downward slide. Although the markets rise during these events, investor risk can actually increase.

Fundamentally our economy is still in a shambles. Jobless rates remain horrible. Many experts are forecasting very high inflation in coming months. The AIG bonus fiasco actually provides a break for congressional leaders because it diverts attention away from these more serious economic problems that impact many more people.

I think the current market situation might be comparable to the lull I experienced last fall when I went several months without losing any chickens. I believed I had weathered the worst. In reality, the greatest risk remained and it came in a manner that I had not considered.

Every time stocks take a few days break during this bear market there are investors and analysts willing to believe the worst is over. My guess is that the risk bubble is not totally deflated yet. And when the next part of this economic challenge confronts us, it might come from an unanticipated corner.
F.S.

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Investors tend to be ruled by emotion. The predominant investor emotion is usually greed. The second most powerful emotion for many investors is fear. Ironically, even during a prolonged bear market like we are currently experiencing, investors who have experienced significant losses and who fear additional losses can be overcome by greed.

We can often see this phenomenon during bear market rallies.

Investment markets have periods of upward movement, even during the most severe and prolonged bear markets. Sometimes these upward moves only last a day or two. Other times they can persist for several weeks or even months. The longer advances that occur during a long-term bear market are commonly referred to by investment professionals as “bear traps.”

The rallies earned this moniker because they lure investors back into the market hoping to recoup some of their losses. Unfortunately, at that point the downward trend resumes and investors get caught and suffer additional losses.

Below is a chart showing performance of the S&P 500 during the prior bear market that began in 2000 and continued through 2002. I’ve highlighted some of the rallies using green arrows and some of the downward moves with red arrows. You can clearly see that there was plenty of both up and downward volatility during this period, but the dominant trend was unquestionable down. From the peak in March 2000 until the bottom in October of 2002, this index lost about 48%.

From the chart you can tell that many of the downward moves are quite substantial. That is where the real danger comes from these bear market traps.  By trying to jump in and out of the market to take advantage of these short-term moves, it is possible that an investor with poor timing might actually lose more than the overall bear market drawdown of 48%. That is also the danger of using short funds in a bear market. By jumping in and out at the wrong times, it is possible to significantly compound the risk and the damage.

Now let’s look at a chart of our current bear market for comparison. Again I have shown the price movements of the S&P 500 and I have highlighted the up and down moves with arrows. From the peak in October 2007 until the most recent low, the index dropped about 55%. It is certainly possible that there could be additional losses going forward. Notice in this instance, the declines have been steeper and more severe and there have been very few rallies.

It is apparent that there have been few rallies of any substance during this corrective market. At Strategis, our trading strategies are not designed to take advantage of short-term market movements. This is an intentional strategy created to avoid whipsaw trades and instead take advantage of longer term trends. So the reality is that we will generally miss the early part of any upward or downward move.

Let’s consider a specific example. After bottoming in November 2008, the index rallied into the first week of the new year, gaining about 17% during that time. Our technical triggers came very close to signaling us to get back into the market at that time. Looking back, that obviously would have been a big mistake, because the S&P 500 has dropped sharply since then. Fortunately we stayed out and appeared to be very smart.

Notice also that over the two bear market periods shown on the above charts, the potential gain for any given rally during a bear market is limited. We all want to make money and that urge can be especially strong after a significant market correction like we are experiencing. Investors who have lost money feel a powerful need to make up those losses. Even investors who have avoided the downturns get anxious because they know eventually a bull market will re-emerge and they want to squeeze as much profit as possible out of it. But these bear traps are times when market risk probably outweighs any potential reward.

This week we have again seen a few days of upward market movement. Is this the beginning of another bear trap, or is this the early stage of a trend reversal and a new bull market? Only time will tell us for sure. But our indicators continue to signal that this is not yet the time to jump back into the stock market.
F.S.

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After the past week, virtually every economist and analyst has been forced to admit that we have yet to see the bottom of this bear market. The Dow, S&P 500 and Nasdaq all reached levels last seen in 1997. If they are honest, economists and analysts will also admit that there is no way to know when and where the bottom will be reached.

We have warned investors for months that market risk remains high and until there is some kind of confirmation that a bottom is in place, the safest place for assets is in a government insured money market fund. That advice is as pertinent today as it was six months ago.

Consider this comment from Paul Volcker, former U.S. Federal Reserve Board chairman, and now a member of President Barack Obama’s economic advisory team. This is from a recent speech he gave in Toronto.

“This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.”

Below is a chart of the Dow Jones Industrial Average from 1970 to the present. It illustrates a couple of important concepts. Be aware that this is a logarithmic chart. That means that the compounding effect has been removed and price movements are proportional. So a 40% decline is going to appear the same whether it occurred in 1975 or in 2008.

I added the red lines to show a couple of extended periods where this index produced zero return on a buy-and-hold basis. The first ended in 1983 when the market began the longest, most powerful bull trend in history. This is important because the majority of people working in the financial industry and the majority of today’s investors began sometime after 1983. Very few of today’s investors or advisors experienced or can remember the prolonged sideways market that prevailed through the 1970s.

Rod Jackson is our primary investment/market analyst, consultant and strategy architect at Strategis Financial Group. Rod began his career in the financial industry in the late 1970s. Rod joined Strategis in 2001 and immediately began warning us that he believed the market was at the beginning of a period of sideways market movement that was likely to continue for up to two decades. This is a pattern that recurred several times in market history.

It was not a message that people wanted to hear at the end of the longest bull market ever. Remember, most investors had never suffered through a significant bear market. So in their experience, the stock market almost always produced double-digit annual returns. Now that we find ourselves in a situation where stocks have a deficit return over the past 10 years, investors seem more receptive to the concept that there can be prolonged periods where market returns are negative. Well known analyst and author John Mauldin in his weekly email commentary noted that if you look at the S&P 500 over the past 100 years, there are many 20-year periods with total returns were less than 3%. If you factor in inflation, there are many 20-year and 30-year periods with negative total returns.

If Rod is correct, we could see several more years of corrective market action. That does not mean that there will not be profit opportunities for investors. On the chart above, look at the sharp correction that ended in 1975. Notice that the Dow recouped the entire loss in just over a year. There were gains to be had for someone with a methodology that allowed him to trade in and out of market cycles and sectors. It does mean that investors cannot simply buy an index fund and expect that they will have a substantial gain after holding it for 10 years or more.

The blue line on the chart marks what Rod Jackson considers is the next level where the Dow will find substantive technical support. In other words, he believes continuing downside risk is about 40% below the current price. The first time Rod told us he thought the Dow could drop to 4,000 it was trading above 11,000. The possibility of that big a decline seemed remote. Now that the index has fallen nearly 5,000 points since that forecast, the possibility of an additional 2,000-point drop does not seem impossible.

Please note that this is not a prediction that the Dow will immediately drop another 40%. In fact, the market is oversold at this level and some kind of an intermediate rally is expected. But most experts are predicting that the recession is likely to continue well into 2010. That leaves plenty of time for both up and down volatility in the markets. This sideways period could easily continue another seven or eight years and still be within that normal 20-year pattern. That means there could be a strong rally for a year or two followed by another downturn where we could see the Dow even lower than current levels.

While Rod Jackson does not profess to be able to predict exactly what the markets will do or when, right now I would not be willing to bet against his assessment of continued market risk.
F.S.

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