Monday, October 27, 2008

To Buy & Hold, or Not to Buy & Hold?

That is the question. To paraphrase Hamlet, “Is it nobler to buy stocks now or wait until complete market capitulation when there's a good chance we could miss out on a major rebound?” Financial pundits have lately been decrying that NOW is the time to get into stocks. They say that many companies have been unfairly beaten down to prices that are well below historical fundamental levels. They're looking at P/E ratios (price to earnings), price to book (how much a company's assets are in comparison with market capitalization), price to growth, price to current sales, price to projected sales, etc. And I don't disagree with them. Many stocks do look enticing, but the real question is:

Can these stocks drop further?
I believe the answer is yes. The major reason the market has dropped so precipitously is because of massive redemptions on the part of hedge funds and mutual funds. They've got to get rid of their inventory and they need to do it by yesterday. Jim Cramer pins much of the redemption frenzy blame on hedge fund of fund managers whom he feels are one step below pond scum on the evolutionary scale. These managers buy and sell hedge funds much like an investor buys and sells mutual funds or individual stocks, so when a particular hedge fund is not performing, these fund of fund managers will pull their position forcing the hedge fund to divest itself of its holdings not to mention its business. (Cramer figures that roughly 30% of all hedge funds will not be around a year from now.)

When can we expect a bottom?
To answer the above question, we need to first answer this one: Are the hedge funds done selling? It's tough to know but one way for the retail investor to tell is to look at volume. The volume on the Dow has been heavy during the past two weeks of selling. Today's volume is on the light side with the Dow essentially unchanged (as of 3:30pm ET). Every time buyers step in, so do the sellers which means the selling pressure is not over with yet.

I know I've mentioned this before but technically I believe the S&P 500 needs to test the 800 level and the Dow has to test the 8000 level. I do believe the VIX will reach 100 before the market finds a bottom. The problem is: I honestly have no idea how low this market can go. Basically, I have no clue as to how much more hedge fund redemption there is left to unwind.

The bottom line
To use CNBC's Bob Pisani's catch phrase, the bottom line is that unless you've got a very long time horizon, buying now could be detrimental to your portfolio. If you truly believe, however, that a stock you love is a bargain, try averaging into it by buying a quarter position at a time. Sure, we don't know when the bottom is going to hit and when it does, the market could rebound through the roof. Am I sure of that? I'm not sure of anything, but I do think there's a good chance it will do just that, but will that be enough for you to make money? Let's consider an example.

Example of how far the market needs to rebound
Suppose company XYZ's stock was trading at $100 just before the onset of the credit meltdown. In just the past two months, it's shed 50% of it's value and is trading at $50. You think now is the time to step in so you buy your full position. The market keeps tumbling and the stock sheds another 50%, down to $25.

Feeling like a fool, you pray for a market bottom. The Good Witch of the Market hears your prayers and stops the bleeding. A bottom is formed. How much will your stock have to rise for you just to break even? One hundred percent, of course. That's a lot to ask of a market rebound. But don't feel too bad—just think how awful you'd feel if you had bought the stock at $100 and are still holding it, like the majority of people with retirement accounts. The stock would now have to rise 300% just for you to break even, and how long to do you think that could take? According to a report I heard on CNBC earlier today, since the depression the average bear market takes three years with the longest bear market lasting eight years. Eight years! Do you want to wait that long for your portfolio to recover?

I think not. So that's why for the next day or two I'll be examining the buy and hold philosophy and comparing it with ones based on market timing and various stop/loss criteria. I'll also examine how shorting in down markets affects portfolio returns. So toss another log on the fire, wrap yourself in your fuzzy throw blanket, brew a cup of cocoa, and settle in for some analysis and discussion of this very important concept that I believe is deluding many people into thinking their retirement accounts are safe. My goal here is not to scare you but to arm you with the appropriate knowledge so that you, too, will be able to avoid “the slings and arrows of outrageous fortune.”

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