Alpha Power Investing Newsletter

March 2, 2020

The Problem with Buy and Hold

In recent months we reached the stage of the bull market where more and more investors consider the "buy and hold forever" approach. And, human nature being what it is, this was not entirely surprising. When the stock market relentlessly pushes to new all-time highs after new all-time highs, it is natural for investors to feel pretty good about things and to recline into the "the stock market always goes up in the long run" easy chair in their minds. What, me worry? Unfortunately - as investors learned once again in the final week of February - this completely ignores the entirely cyclical nature of the stock market over time.

Before getting into all of that, let's make an important distinction here. Putting a portion of one's portfolio into the stock market and leaving it there - essentially until you actually need the money - is a fine approach to investing. On the other hand, putting ALL of one's money into the stock market and resolving never to sell, is what we refer to as a "drifting with the tide" strategy. If the sky is clear and the seas are calm, then it's smooth sailing. But storms are inevitable for both the weather and the stock market. And the longer the sailing has been smooth, the more people forget about the storms.

Ironically, many investors who embrace the buy-and-hold approach do so because they believe that there is no way to time and/or outperform the market. This is ironic because as it turns out, the actual long-term success of buying-and-holding is primarily a function of which years you happen to be in the market. As we will highlight momentarily, the market can and has moved sideways for surprisingly long periods of time. History has demonstrated quite clearly that a buy-and-hold investor who gets in at the wrong time can wait a very, very long time before making any significant return. Particularly if they buy in when valuation levels are on the high end of the historical range.

But as the stock market made new all-time highs in recent months, more and more investors no longer concerned themselves with market history.

First the Good News
Going into the last week of February the trend in the stock market was unmistakably bullish. That statement should not come as a surprise to anyone. When the major indexes - the Dow Jones Industrial Average, the S&P 500 Index, the Nasdaq 100 Index and the Russell 2000 index - are all making new highs and trading above their respective 200-day moving averages, it was simply illogical to argue that "we are in a bear market". But therein lies the danger. The more investors get used to being in a bull market, the more they forget about the kind of trouble that typically comes around with some regularity. And as we have just seen, declines can often be swift and severe in nature.

Now the Bad News
The first piece of bad news is that stocks are overvalued and have been for some time. Now that fact hardly scares anybody anymore - which actually is understandable since the stock market has not been officially "undervalued" since the early 1980's. Also, valuation is NOT a timing tool, only a perspective tool. So, here is some perspective:

  • Recession => Economic equivalent of jumping out the window.
  • P/E Ratio => Tells you what floor you are on at the time you jump.

Therefore:

  • A high P/E ratio DOES NOT tell you WHEN a bear market will occur.
  • A high P/E ratio DOES warn you that when the next bear market occurs it will likely be one of the painful kind.

Figure 1 displays the Shiller P/E Ratio plus the magnitude of the bear market that followed previous important peaks in the Shiller P/E Ratio.

Figure 1 does not tell us that a bear market is imminent. We don't know when the Shiller P/E Ratio will peak or how high it might climb before doing so. However, with the Shiller P/E Ratio presently at one of its highest levels ever, it may be instructive to consider how the stock market has performed following previous peaks in this ratio:

1929: P/E peak followed by -89% Dow decline in 3 years
1937: P/E peak followed by -49% Dow decline in 7 months (!?)
1965: P/E peak followed by 17 years of sideways price action with a -40% Dow decline along the way
2000: P/E peak followed by -83% Nasdaq 100 decline in a little over 30 months
2007: P/E peak followed by -54% Dow decline in 17 months
Following next peak: ??

As you can see, history suggests that the next bear market - whenever it may come - will quite likely be severe. Yet, there is actually another associated problem to consider. Drawdowns are one thing - some investors are resolved to never try to time anything and are thus resigned to the fact that they will have to "ride 'em out" once in a while. But another problem for investors trying to execute a long-term financial plan is going an exceedingly long period of time without making any money at all. Most investors have pretty much forgotten - or have never experienced - what this is like.

Figure 2 displays three such historical periods - the first associated with the 1929 peak, the second with the 1965 peak and the third with the 2000 peak.

To wit:

  • From 1927 to 1949: the stock market went sideways for 22 years. Which means that money put into the Dow Jones Industrial Average stocks in 1927 finally got back to breakeven in 1949.
  • From 1965 to 1982: the stock market went sideways. While this is technically a 0% return over 17 years (with drawdowns of -20%, -30% and -40% interspersed along the way), it was actually worse than that. Because of high inflation during this period, purchasing power declined a fairly shocking -75%. To put it another way, money "put to work" in say a S&P 500 Index fund in 1965, 17 years later had only 25% as much purchasing power as it did when the money was first invested.
  • From 2000 to 2012: the stock market went sideways. With the market presently at much higher all-time highs most investors have forgotten all about this difficult period that included two major bear markets. Still, it is interesting to note that from 8/31/2000 through 1/31/2020 (19 years and 5 months), the average annual compounded total return for the Vanguard S&P 500 Index fund (ticker VFINX) was just +5.75%. Not exactly a stellar rate of return for almost 20 years of a "ride 'em out" in an S&P 500 Index fund approach.

The Bottom Point: When valuations are high, future long-term returns tend to be subpar - and YES, valuations are currently high.

What to make of all this?

As we stated earlier, committing a portion of one's portfolio to the stock market on a long-term buy-and-hold basis can certainly make sense. But committing all of one's portfolio to the stock market on a long-term buy-and-hold basis leaves you entirely at the mercy of the market. As we have demonstrated in the history above, "When things are swell, things are great". But "things" are not always "swell". With the extended bull market we have enjoyed in the past decade, many investors are forgetting this important point.

The strategies offered by Alpha Investment Management are designed to be "all-weather" strategies - i.e., designed to make money in a bull market and to preserve capital and reduce volatility during an extended bear market. We expect them to perform well over time "whatever the weather". As a reminder, the proper way to measure the long-term performance of any investment strategy is to consider total return from bull market high to bull market high and from bear market low to bear market low, i.e., across a full bull/bear cycle.

Jay Kaeppel
Director of Research
Alpha Investment Management, Inc.
877-229-9400
www.alphaim.net
info@alphaim.net

Disclosures and Disclaimers: Past performance is not a guarantee of future performance. The returns illustrated in the charts above do not represent actual trading and are not representative of the returns of any strategy. The illustrations are designed to quantify the effect of certain time periods on various stock market indexes as specified. Indexes are not investment vehicles and persons cannot invest directly in an index. Index funds and ETFs may vary somewhat from index returns due to management fees and portfolio structure. The data used to construct the illustrations was obtained from third-party sources. While Alpha believes the data to be reliable, no representation is made as to, and no responsibility, warranty or liability is accepted for the accuracy or completeness of such information.

The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security. Before investing in any fund and/or strategy, investors should consider the investment objectives, risks, charges and expenses of the fund/strategy and its investment options.  

Alpha Investment Management, Inc. is a SEC registered investment advisor located in the State of Ohio. Such registration does not imply a certain skill or training and no inference to the contrary should be made. The information and opinions expressed in this document are for informational purposes only. Any recommendation or opinion made in this document may not be suitable for all investors. The information contained herein does not constitute and should not be construed as investment advice, an offering of investment advisory services, or an offer to sell or a solicitation to buy any security.  

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