August 19, 2011

Buy and Hold, but Don’t Look

Gundlach and Roubini are among those counseling avoidance of stocks; but that doesn’t mean investors should go to cash

We’ve become conditioned over the last few years of this Great Recession to negative data, but S&P’s downgrade of U.S. debt securities—following an ugly fight in Washington over lifting the debt ceiling—seems to have marked a turning point in global markets. Of course this happened at the same time Europe’s sovereign debt crisis threatened to spread its contagion to Spain and Italy—countries thought “too big to bail”—so the increased level of shock sent a powerful market signal to run for cover.

After all, government debt securities of advanced market economies were always seen as the conservative floor from which investors could securely venture out to riskier assets. When “safe” investments become scary, it eventually must affect the psyche of the investor.

In this context, weak home sales, new unemployment claims, sluggish manufacturing, signs of inflation and forecasts of imminent recession become more than just the same-old, new-normal bad data. The market blithely ignored such data in the huge bull runs of 2009 and 2010. The trouble is today’s environment is starting to feel an awful lot like 2008.

Eminent voices on Wall Street are capturing this zeitgeist. DoubleLine’s Jeffrey Gundlach has warned of a “serious possibility of a global banking panic” like we had in 2008. He notes that European banks sitting on mountains of toxic debt are closely tied to U.S. banks through swap contracts as we saw three years ago with AIG. He called this week’s market mayhem a “small drop” that should not be seen as a buying opportunity.

Economist Nouriel Roubini, in a video interview with the Wall Street Journal a week ago, was among many others counseling investors to avoid stocks at this time. He said: “We don’t know whether this volatility is temporary and things are going to improve or whether there’s going to be a nasty recession and another 30-40% fall in equity prices. So until the fog of uncertainty is resolved, my view is that it’s better to be safe rather than sorry. This is not the time to be in risky assets.”

To anyone who has been following the world economic situation recently, it seems hard to dispute this. But consider the fact the economy and markets don’t track each other perfectly in the short-term. If they did, the market should have plummeted in 2009 and 2010. Far too many poor suckers were “right” about the market crash a year or two or three in advance.

In 2008, there were lots of articles with the theme that “buy and hold is dead,” but far deader were those who liquidated their portfolios in panic and then waited more than two years for the market to pause to get back in. Well, here’s the pause you’ve been waiting for, right?

I am not arguing that the recent retreat of the market is a buying opportunity. Further declines seem likely to me. What’s more, my expectation is that economic conditions will deteriorate further for at least another year. But I have enough experience watching the market to know that short-term movements are hard to predict on a consistent basis and that trying to do so involves too great a risk of wealth destruction.

So here’s my advice to investors. To the standard and not always satisfying “buy and hold” axiom we should append “and don’t look.” Quarterly reports can be frightening, monthly reports downright terrifying. They all go against the very idea of an investing strategy, which is inherently long-term. If the strategy is sound, there is no need to take any action on capital that has already been invested. The wise course is to adopt an investment strategy with your eyes wide open, but once adopted to keep them tightly shut.

It is the nature of human beings in general and investors in particular to be highly insecure about their wealth. No matter our individual “risk tolerance,” we all tend to buckle when faced with losses. Behavioral finance research shows that the pain of loss is felt with approximately two and half times the intensity as the joy of gain.

The last decade was a lost decade in the financial markets, and the present one could be as well. But with a long-term horizon and adequate diversification, investors will come out ahead. And besides, what alternative is there given that the asset class historically understood as “safe” has never held greater risk.

Treasury securities depend on two things: responsible management of debt and a government’s ability to tax private wealth–two bedrocks that have cratered in recent times. While stocks are considered “risky assets,” they are based on companies selling goods and services that people need and want. If that ever stops, there will be nothing for governments to tax, so bonds will be worthless and cash useless; but that of course would be the least of our problems.

If you’re invested in the market, stay in … and don’t look.

Page 2 of 2
Single page view Reprints Discuss this story
This is where the comments go.