Tuesday, May 19, 2009

Does the Latest Market Rally Validate Buy and Hold Investing?

Lately I’ve been asked if the latest market rally, a record breaking move of 38% or so over the past few months, validates the idea that investors should just buy and hold stocks. For the record, there is no market move, either up or down, that validates the idea that valuations don’t matter and investors should blindly own stocks expecting to earn historic average returns regardless of the market’s value when they buy. However, I thought I would do some “back of the napkin” math to put this rally is some perspective.

If you bought the S&P 500 in March of 1998 and reinvested your dividends you would, as of Friday’s close, have almost exactly broken even on your investment. The actual price of the index on March 16, 1998 was 1,079. If you invested in the Vanguard Total Bond Market Index Fund on the same date you would have earned an annual return of 5.57%, very close to the expected returns for bonds if you made the sensible assumption that inflation was going to be 3% for the period. However, the historic premium for stocks over bonds is about 6%, so if you purchased stocks in March of 1998 with the expectation of buying and holding and earning the historic risk premium, you would expect to earn about 11% per year.

Here’s the bad news. If the S&P actually earned the 11% that was expected in order to validate the assumptions of buying and holding, the S&P would have to trade to a price of 3,400 tomorrow, a gain of 277%. If we look at today’s 10-year normalized (average) S&P earnings of $50, the market would have to trade to an unbelievable P/E ratio of 68 at that price. Or, let’s say you are a raving optimist and think investors would reward the stock market with a multiple of 30 times earnings, a prospect that is doubtful at best. In such a case, S&P earnings would have to impossibly and immediately grow by 126% to $113. The recent 38% rally in the stock market does nothing to validate the idea of buy and hold investing, unless we are going to rally an additional 277%. Notably, the volatility of stocks was five times more than bonds for the period, raising the question of what premium return would have been considered acceptable for investors who ate 5 times more volatility to earn it.

By the way, the next time the market gets to a PE multiple of 30, I will be happy to sell my stocks to the investors who want to buy and hold.