The Great Buy and Hold Fallacy Debunked Again

— by Anthony Jasansky, P. Eng.

The devastation of this once-in-a-century bear market has gone beyond equity and credit markets. Over the last 18 months, the big “bad” bear has also rendered useless many of the sophisticated market theories and models, as well as various investment rules and assumptions derived from market behaviors in the years following World War II.

The Efficient Market Theory, a subject taught in all schools of economics, has been left with big holes. Models designed by Math PhDs in the employ of Wall Street and simpler concepts such as the once popular Fed Model have all bombed out.

Among the assumptions to go up in smoke was the widely accepted inverse correlation between the U.S. Federal Fund Rate and the equity markets. Instead, since the early 2000s, equities actually have trended down during periods when the Federal Reserve reduced interest rates and vice versa. In the end, this primary monetary tool the Fed has used for decades finally hit a wall when the Fed lowered the federal funds rate to the 0%-0.25% range earlier this year.

The failure of “the buy and hold investment premise,” the favorite mantra of the mutual fund industry and its salespeople, is well demonstrated by the 55% decline in assets of mutual funds over the last 16 months. Though the drop was partially due to redemptions, most of the decline was due to funds being fully invested during the market carnage.

Investors also found that global and industry sector diversification has not prevented large losses. Even the few strategies that held up relatively well, namely bonds/equities or the commodities/equities diversification models, failed over the latest eight to 10 months, as commodities and bonds (other than U.S. Treasuries) collapsed.

The increasing evidence that many of the tools that had worked well for 50 odd years were failing was among the reasons why I expressed my disbelief and apprehension when my own stock market model hit the bullish zone in March 2008. My comments over the failure of so many investment methods and assumptions during this bear market could be summarized in one sentence: “It has been different this time.” On a more positive note, market conditions never remain static and, at some point, some of the old tools may start to work once again.

When analyzing why my stock market model has also lost its effectiveness in recent years, the portions of the model concerned with fundamental and monetary indicators were found to be the worst performing component. Based on yield spreads between equities and treasuries, their failure reflects the Fed’s failure to continue to manage the U.S. economy by changing interest rates. Even the originator of the rule, “Do not fight the Fed and do not fight the tape,” would agree that only the second half of the rule has withstood the test of time. The old days of the Federal Reserve lowering interest to boost the economy are gone.

To conclude my rumination about the failure of analytical methods and rules, the chart of weekly NYSE stocks hitting new highs/lows (a very popular indicator) shows that not all methods and indicators have failed during these trying times. My work would have been a lot simpler and maybe more profitable had I known, 10 years ago, how well this simple technical formula would perform.