“Buy and Hold” Doesn’t Work in The Stock Market When…

This article was originally published for RC Peck’s Fearless Wealth Newsletter in April 2004.

Earlier this year, when I started the edit and rewrite of my book Fearless Wealth, How to Grow and Harvest Your Money, I decided to take a look at what has changed in the market since the book was first published in 1998.

The first thing I noticed was what hadn’t changed, which means history had followed a proven set of rules, and I noticed that the rules need to be even simpler. The rules I teach are based on historical information, and as I mentioned before, understanding history helps IF you believe that the “human condition” hasn’t changed. The book rewrite triggered further investigation of historical data.

As some of you may know, I put price action above all other information. This involves looking at a price chart. Price action has to do with the direction in which the price of a stock is moving. I put price action above everything else because people make or lose money based on the price of their stock going up or down.

Now compare this approach with fundamentals-based and other traditional investing methods. Fundamentals-oriented investors use metrics like price-to-book ratios, price-to-earnings (P/E) ratios, balance sheets, overbought or oversold, cash-on-the-books and other traditional evaluators. While a stock’s price action can be down (read: Enron, Worldcom, Global Crossing), its fundamental action can be great and getting greater.

Because price action is what makes (or loses) people money, this is what I’ve used and suggest you use. And even though I’m a big proponent of price action, I have made a few discoveries on P/E ratios that are worth noting:

  1. The market P/E ratio indicates when the market is cheap or expensive.
  2. The stock P/E ratio indicates when NOT to buy and hold.
  3. If you are going to hold a stock for less than a year there are zero fundamentals you need to look at—the time frame is too short.

It’s important to know which way the market is trending because the trend will pull 75% of stocks in the same direction. If Joe or Jane Public knows the direction of the overall market, he or she has a pretty good idea that 75% of stocks will be moving in the same direction. This is true whether the market is moving up or down.

Historically speaking, when the S&P 500 has a P/E ratio above 30 you might want to reconsider buying and holding. Here’s why: Buying and holding only works when something is cheap and moving up. If Joe Public has been inculcated to believe that “buy and hold” is the only strategy, he might not think about the expense of the market (i.e., the value of stocks).

When the market P/E ratio for the market is above 30, and Joe or Jane buy and hold, he or she will have to wait more than 20 years to get his or her money back. Joe or Jane will not make money on their buy and hold strategy over the next 20 years statistically speaking. In fact, after 20 years of holding, Joe or Jane will still be down 2 percent. Hold for 20 years and have a negative 2 percent return? I don’t think so.

Let me repeat that, because we are currently in this range of P/Es. The current market is very expensive and it is not the time to buy and hold. Based on historical data, when stocks are purchased and held at these levels, the outcome is a negative 2 percent return on the investment after 20 years. That is a long time to have money not working for you.

The first reason Buy and Hold is the go to strategy on Wall Street is that brokers make money by using it. It keeps Joe and Jane Public in the market. The second reason is a study that came out a while ago by a Yale professor named Ibbotson. The study states that if you buy and hold the market, your money will grow over time. The flaw in this study is that it is based on a 70-year holding period. I’ve yet to meet anyone who buys when he or she is 1 year old and then sells at age 70. History shows that the average holding time is 20 years.

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Now let’s turn from market P/Es to individual stock P/Es to gain more insight. If Joe Public were going to buy an individual stock and hold it forever, he should know that any individual stock purchased with a P/E ratio of 100 or above has never returned the investor’s money. “Never” is a pretty strong word, so just to make sure that we are in agreement, “never” means that it has never happened; it doesn’t mean that it will never happen.

If you pull up any stock website and start looking at P/E ratios of brand name companies, you will see that there are a lot of them with P/Es over 100. Ouch! There is going to be some pain in the future if Joe or Jane uses a buy and hold approach.

The lesson:

  1. Buying and holding only works when the market is cheap (this means a “reported” P/E ratio below 14).
  2. Be wary of buying and holding individual stocks with P/E ratios north of 100.
  3. If you’re going to hold a stock for less than a year, then it’s fundamentals do not matter.
  4. Price charts never lie. And you make or lose money based on the movement in the price of the investment you own.

To being an informed consumer and growing your wealth.

With regards,
RC’s Signature