‘Buy and Hold’ May Face New Test

When Internet-based brokerages were adding customers by the millions in 1998 and 1999, some Wall Street veterans warned that the ease of buying and selling stocks online would turn long-term investors into short-term traders--with ruinous results.

As it turned out, what ruined the portfolios of many new online investors was that they didn’t trade enough: They bought technology stocks on the way up, or during the first big sell-off in spring 2000, and then held on--riding the shares into oblivion by late last year or early this year.

Questioning buy-and-hold investing used to be considered blasphemous. But the market’s extraordinary volatility of the last few years, and the hefty losses people have suffered by staying too long not just in tech but also in such blue-chip names as Coca-Cola and Eastman Kodak, have reminded investors that there comes a time to say goodbye to a stock.

The next few years could bring that lesson home again and again. Today, most arguments about the market’s future have bulls on one side and bears on the other.

The bulls say stocks have bottomed, or are in that process, and will produce healthy long-term gains from these levels.

The bears say the latest market rebound is just another rally in an ongoing bear market and that prices will get substantially cheaper from here.

Little discussed is a third scenario: Stocks could witness both powerful rallies and steep declines in the next few years, but with the end result by, say, 2005, being no net gain for buy-and-holders.

That would be a classic “trading-range” market--one in which many stocks bounce around a lot, but don’t make much, or any, net progress.

Because the late 1990s were so spectacular on Wall Street, with the blue-chip Standard & Poor’s 500 index rising more than 20% a year for five straight years, it’s probably hard for many investors to imagine stocks being stuck in a prolonged trading range.

But it has happened before, in varying durations, with the market overall and with plenty of individual stocks.

Consider: The S&P; index, perhaps the best proxy for a diversified portfolio of big-name stocks, was virtually unchanged in the three years ended in March 1979.

The index didn’t simply flat-line in that period. It tumbled 19% from its 1977 high to its 1978 low, followed that with a 22% gain by October 1978, then slid again. So there was action.

But the patient buy-and-hold investor who owned an S&P; 500 index mutual fund for those three years had no price gain to show for it at the end.

More recently, the S&P; eked out a mere 5% net gain between the end of 1992 and the end of 1994.

Perhaps the most famous example of an extended trading range--or at least the one that strikes the most fear in the hearts of long-term investors--was the Dow Jones industrial average’s trend between 1965 and 1980.

After rocketing 400% from 1949 to the end of 1965, the Dow began 1966 at 970. Fifteen years later, it would finish 1980 at 964. In between was a sequence of bull and bear markets. But after 15 years, a Dow portfolio had no net price gain.

It’s true that the broader market performed better than the Dow between 1965 and 1980. Even so, there were a lot better things to do with your money in those 15 years than buy and hold many stocks.

Could history repeat? It’s popular to view the 1970s as a period in which every card was stacked against the stock market: The economy was a mess, inflation and interest rates were soaring, and commodity shortages attracted speculators at stocks’ expense.

This decade may be off to a lousy start, but nobody yet is drawing comparisons to the ‘70s.

Still, the idea of a multiyear trading range for the stock market--as opposed to a sustained bull market or a sustained bear market--isn’t farfetched to some Wall Street veterans.

“One argument is that we’re overdue for that kind of market,” said Dan Sullivan, editor of the Chartist investment newsletter in Seal Beach.

Mark Hulbert, whose Annandale, Va.-based Hulbert Financial Digest tracks trends in scores of financial newsletters, says a trading-range market is an interesting “contrarian” bet now--because it isn’t what most financial pros are expecting.

The fundamental argument for a prolonged trading range goes like this: The tremendous gains that many stocks enjoyed in the 1990s left them at historically high valuations relative to earnings. Those valuations have come down from their peak levels, thanks to the bear market, but they still are far from cheap.

While Wall Street’s bulls believe that corporate profit growth will resurge in the next few years from current depressed levels, there are reasons to believe that generating significant earnings growth will be a tougher game for many companies. Those reasons include higher debt loads at many firms, rising energy costs and the potential for a slower-growing economy overall.

Now, over the last month, the market has clearly been betting on a better earnings picture in 2002 and beyond. Despite Friday’s dismal April employment report stocks rallied broadly. The S&P; 500 has risen nearly 15% from its two-year low reached April 4.

But the risk in a continuing rebound in stocks is that prices will quickly come to reflect whatever profit gains are in store in 2002 and perhaps beyond.

“A good rally will reflate price-to-earnings ratios,” warned Tim Hayes, global equity strategist at financial research firm Ned Davis Research in Nokomis, Fla. “At that point, I think there will be more risk aversion by more investors”--in other words, people will remember how dangerous it was to overpay for stocks in 1998, 1999 and 2000, and they’ll shy away.

What’s more, as stocks rise they could face selling pressure from investors who got in at much higher levels in recent years, have held on and would be happy to sell if they just get back to even.

Thus, rallies could quickly give way to renewed sell-offs, or at best to flat periods for many stocks.

Yet in the absence of a recession or soaring interest rates, there would be no overwhelming reason for investors to bail out of stocks entirely or push prices markedly lower. Hence, a trading range could ensue.

Of course, even in an environment in which the market overall treads water, some stocks would be stars. That’s inevitable in an economy, and market, of this size.

Watching those stars would naturally keep many people’s interest in stocks piqued. But it would also make it more painful if your own portfolio did little but move sideways for years.

The worst thing about a trading-range market is that it would leave many investors with two lousy choices: Maintain a buy-and-hold strategy and put up with poor or negative returns for a sustained period, or try to time the market’s swings within the trading range, buying more when prices seem low and taking profits when prices seem fair or high.

Many investors, understandably, will reject the idea of wholesale market timing. It’s too difficult.

Still, given the experiences of the last few years, at a minimum a trading-range market may demand that investors heed a gut feeling that tells them a particular stock has become overvalued, or that a company’s prospects are no longer what they were when the stock was purchased.

Saying goodbye can be painful, but it can be even more painful to stay in an investment whose time has passed.

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A note on last week’s column: A Treasury Department Web site was misstated in last week’s column. The correct address: https://www.publicdebt.treas.gov

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Also, investors interested in inflation-protected bonds can find a good discussion of the topic on Morningstar Inc.’s Web site. Go to: https://news .morningstar.com/doc/article/ 0,1,4227,00.html

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Tom Petruno can be reached at tom.petruno@latimes.com.

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The Nowhere Dow: 1965 to 1980

The 30-stock Dow Jones industrial average boomed and busted several times between 1965 and 1980, but for most of that period the blue-chip index was stuck in a trading range of between 800 and 1,000. Savvy traders could have made money playing the rallies, but buy-and-hold investors were left with virtually no net price gain after 15 years.

Dow Jones industrial average, quarterly closes

1980: 963.98

Source: Bloomberg News

Four Years, Still Waiting

For some blue-chip stocks it hasn’t just been a bad 12 months. Some have been stuck in trading ranges for so long that, at best, they’e generated little net gain for their shareholders in four years.

Stock: Price change since April 1997

Walt Disney: +13.4%

Proc. & Gamble: +2.2

McDonald’s: +0.3

AT&T;: -1.5

H.J. Heinz: -3.4

Intl. Paper: -8.8

DuPont: -13.0

Coca-Cola: -26.4

Gillette: -33.8

Eastman Kodak: -44.9

S&P; 500: +58.1

Source: Bloomberg News