Is Now A Good Time To Exit From Buy-and Hold Investing?

• By Simon Maierhofer
• On 12:09 pm EDT, Thursday July 30, 2009

The area was known to be an idyllic sanctuary. Snowcapped mountains, crystal clear lakes, warm summers, a gentle autumn ... you get the picture. For nearly 180 years, Mount St. Helen had laid dormant, towering over the beautiful scenery below.

Early warning signs by many were viewed as nothing more than hot air (no pun intended). Doug, a farmer who lived close to the foot of the mountain resisted evacuation efforts, 'my mountain wouldn't do that to me' he said. Less than 24 hours later, Doug and his farm were buried beneath 70 feet of mud.

What's the moral of this story? Just because an event doesn't occur regularly doesn't mean it can't happen.

The unexpected is never expected

When it comes to investing, this real life experience has many parallels. 2008 has been a unique year and shattered many of the market's decade-old patterns and habits, along with strategies designed to benefit from those patterns.

Throughout the 20th century, you could buy shares of a solid company like General Electric or Exxon Mobile, reinvest the dividends and watch your money grow. Even though this approach wasn't a thrill ride, it got the job done. The 1980s and 1990s added the excitement the former decades were lacking.

Microsoft, Cisco, Dell and many once fail-prove funds like the Fidelity Contrafund (Nasdaq: FCNTX - News), or Vanguard 500 Index Fund (Nasdaq: VFINX - News) consistently delivered the type of growth that turned CD-holders green with envy.

Expectations for the 21st century were high until the bust of the dotcom bubble sent the Nasdaq (Nasdaq: ^IXIC) and Technology Select Sector SPDRs (NYSEArca: XLK - News) spiraling.

Following this painful dose of reality, the market recovered starting in 2002 and - fueled by easy credit - went on to climb to new highs in 2007, at least the S&P 500 (SNP: ^GSPC) and Dow Jones (DJI: ^DJI) did, the Nasdaq, even at its secondary peak, was still 46% below its 2000 highs.

A bright future?

Once again, the future looked bright. In its Global Economics Report, Merrill Lynch's analysts expressed optimism: 'The Merrill Lynch global economics team believes that the economy will continue to grow in 2007 - with no sign of a significant cyclical slowdown. The bank's economists are more bearish than most on the prospects of the U.S. economy, but are more bullish than consensus about the rest of the world.

Within a month of this very report going to press, the stock market started its descent, this time lead by the financial (NYSEArca: XLF - News) and real estate (NYSEArca: IYR - News) sector. Merrill Lynch's analysts weren't bearish enough to see their own demise and their bullish viewpoint about world markets didn't pan out either.

This brief history encapsulates the pain buy-and hold investors have been experiencing. Many have dubbed the past ten years the 'lost decade.' This is actually an understatement. $100,000 invested in the S&P 500 (NYSEArca: SPY - News) ten years ago would amount to only $71,940 a loss of 28.06%.

Dollar-cost-averaging in a bear market

There seems to be a misconception that dollar-cost averaging miraculously prevents portfolios from declining. No doubt, dollar-cost averaging into your buy-and hold position has its merits. Despite the bull market leading up to the 2007 highs and the recent rally, dollar-cost averaging (investing when values were low and high) would have lost money.

$10,000 invested in the S&P 500 once every year over the past 10 years would be worth a mere $85,478 today.

Buy-and hold alternatives

When Doug - the farmer at the foot of Mt. St. Helen - saw the first spouts of ashes, he should have taken the clue and evacuated the area. Once the avalanche of mud and lava was underway, as fast as 150 mph, escape was impossible.

Now is the season for buy-and hold investors to review and adjust their approach. After rallying for nearly five months, valuations have returned to a respectable level (from a seller's point of view - still overvalued from a buyer's point of view, more about that in a moment).

In the beginning of March, at a time where many wanted to sell, the ETF Profit Strategy Newsletter encouraged investors to hold on to their stocks, 'a multi-month rally, the biggest rally since the October 2007 all-time highs, should lift the indexes by some 30-40%. Tuesday's 4% spike may be an indication of the initial intensity of the rally.'

Even better, in December 2008, the newsletter recommended to sell stocks and buy short ETFs above Dow 9,000. From January 2nd to 6th, the Dow Jones (NYSEArca: DIA - News) hovered above 9,000 providing a great opportunity to buy short ETFs. The target given for a temporary bottom was Dow 6,700 or below.

While stock market speculation or day trading bear many risks, a pro-active approach often proves to be a sweet spot when it comes to wealth retention and portfolio growth. There is no need to watch your portfolio every day, just as watching the weather forecast every day is not necessary because you live next to a dormant volcano. However, when there are real warning signs it makes sense to pay attention and evacuate.

Evacuation in terms of investing means moving money from riskier areas to cash, until the storm blows over. It's a necessary protection mechanism. Trying to withstand a hurricane just because you've survived a rain storm before makes about as much sense (actually no sense) as sticking to buy-and hold investing just because it has worked during yesteryear's bull market.

The buy-and hold approach was one of the worst performance investment strategies during the Great Depression. Every uptick in prices (there were five 25% - 48% rallies from 1929 - 1932) was followed by lower prices. Every one of these rallies sparked the belief in a revival of buy-and hold. Every subsequent decline buried the revival theories.

Buy and hold' on hold - for how long?

Some feel that a comparison of current events to the Great Depression is too doomsdayish. A look at the pillars of world trade shows that the current decline is actually worse than any other decline, including the Great Depression.

The decline in industrial worldwide production is more anemic then it was in 1929/1930. Global stock markets have fallen harder and faster in recent history than they did 70 years ago. The volume of world trade is drying up at a faster pace than seen during the Great Depression and government surpluses are the lowest in 100+ years.

Most importantly, valuation measures such as dividend yields and P/E ratios have not reached ground zero levels indicative of a market bottom. Over the past 100 years, the market has never bottomed unless valuations reached rock bottom levels. History teaches us that the market is not healthy unless that occurs just as the human body is not healthy unless its temperature clocks in at 98.6 degrees.

Unlike the Great Depression, investors now have short and leveraged short ETFs at their disposal to profit from a tumbling market. Such short ETFs can be linked to the S&P 500 (NYSEArca: SDS - News) financial sector (NYSEArca: SKF - News) and many others. Similar to the March 2nd Alert, subscribers to the ETF Profit Strategy Newsletter will receive a Trend Change Alert when the stock market is about to roll over.

Farmer Doug didn't think his mountain' would explode on him, yet it did. Many investors today believe the market will not collapse on them. We've seen what a false sense of security can do. When the warning signs are visible, it's only prudent to act accordingly.

Buzz up!