THIRTY MONTH OLD BEAR market can cause a lot of strange things. Many investors have abandoned stocks entirely while others have been badly burned by taking the wrong side in the market's many false starts.

It's understandable that small investors would encounter these problems, but the pros have had their problems, too. These are the people who make a living studying the market on a daily basis, yet they're not immune from exaggerations and false generalizations either.

Consider, for example, Michael Kahn, one of today's best technicians. After surveying the ongoing bear market and current trading patterns, he was quoted in Barron's Online as saying

It's becoming clearer and clearer that this decade will be no time to buy stocks and lock them away. A little attention to the market will go a long way...This is shaping up to be a flat decade, punctuated with great opportunities for both bulls and bears who eschew the once-venerable mantra of buy and hold.

In other words, given current volatility, this is a trader's market where the "buy and hold" approach no longer works. Mr. Kahn isn't alone in this belief as many active managers have expressed similar opinions.

But is buy-and-hold really dead? Is this simple strategy yet another victim of the aging bear?

Defining Terms

But that's not entirely fair to the buy-and-hold strategy. By its very nature, buy-and-hold is a long-term approach. While the past 30 months may seem like they've lasted forever, most investors would consider that to be a short-term time frame.

In contrast, "long-term" is usually defined as at least five years, ten, or maybe even longer. Long-term investing is for retirement, children's college education, or wealth accumulation. The buy-and-hold approach is appropriate for these goals, but not for 2-1/2 year time horizons.

So can we conclude based on the past 30 months of market volatility that buy-and-hold won't work over the next decade? As we've conceded, it certainly hasn't been successful so far, but even going back to the start of the bear market, there are still 7-1/2 years remaining in the decade. What can we expect from them?

To answer this question, we turned to the Ibbotson data going back to 1926. Since Mr. Kahn's statement refers to "this decade", we took ten years to be the buy-and-hold time horizon. This gave us 67 different ten-year investment periods.

Next, in order to approximate what a real investor would experience, we had to define a sample portfolio. Typically for studies of this nature, you'd look at broad indexes such as the S&P 500, but most investors wouldn't hold and manage a 500 stock portfolio.

They might, however, hold 30 of the largest domestic equities like those comprising the Dow Jones Industrial Average. That average therefore, became the basis of the study.

To keep things simple, we only looked at capital appreciation, not dividends. As you know, an investment's total return is a combination of both, but to be fair to Mr. Kahn and other technicians who only focus on price movement, we thought it would be best to ignore dividends.

Also in using the Dow Jones Industrials as a proxy for a buy-and-hold portfolio, we should point out that the holdings do periodically change. Nevertheless, buy-and-hold investors do occasionally trade, too, so the limited turnover of the average shouldn't be taken as distorting our results.

67 Years of Buy-and-Hold

The Dow was down in 11 of the 67 measurement periods. Four of those periods (1926, 1937, 1968, and 1972) had losses of less than 1% which would have been covered by the dividend. In the other seven instances, one might say buy-and-hold didn't work.

Looking at Chart 1, you can see that the 10% of the time when buy-and-hold didn't work was when stocks were purchased before and held through a recessionary period. These points are confined to those who bought and held in the mid-1920s and mid-1960s. The former suffered through the Great Depression while the latter experienced the "stagflation" of the 1970s.

Will the next 7-1/2 years mimic either of those? Obviously no one knows for sure. Nevertheless, economists generally agree the recession that started in mid-2001 ended in the first quarter of this year. Although the outlook for the coming year is still rather cloudy, none but the most bearish economists foresee anything akin to the Great Depression or even stagflation on the immediate horizon.

If anything, the current bear market has already outlived the historical 9-month average. With stocks now more fairly valued, one might think a buying opportunity is not far away.

The Market Context

Equities are only one part of the overall market. Fixed income investments are the other major factor. Over the past three years, as stocks have foundered bonds have handily outperformed. The basis of this outperformance has been declining interest rates.

Present interest rates -- as defined by intermediate government bonds -- are hovering near historical lows. In the past, a low interest rate environment has been the precise time to buy stocks.

This is illustrated in Chart 2 which again shows the 10-year Dow Jones capital appreciation but now compared to the intermediate government bond yield at the beginning of the decade.

Notice how the worst 10-year returns occur when interest rates at the beginning of the decade are near their relative highs. This even holds in the 1990s when equity returns that were already high actually increased late in the decade as rates fell.

More importantly, notice how many of the best 10-year equity returns occurred when interest rates were near their lows. This is particularly noticeable in the period from 1941-1957. Throughout that period rates were relatively low and stocks provided consistently good performance.

(In an effort to see if there was a definable relationship between rates and 10-year returns that might be useful in predicting future returns, we ran a regression on the two. Unfortunately the results were not statistically significant.)

Intuitively this is quite reasonable. When interest rates are low, bonds offer little investment alternative to equities. As today, inflation is not perceived to be a threat and monetary policy is lax, providing plenty of liquidity for capital investment.

This environment is typically favorable for companies and their stocks. Inasmuch as the economy is slow to reverse course, these positive conditions can last for quite some time.

Which brings us back to today's environment. With interest rates near 40-year lows, almost non-existent levels of inflation, and P/Es back in historical ranges, wouldn't it stand to reason that the coming years may be favorable for stocks?

There's no denying that the past three years have been lousy for equity investors, but that's not the long-term. A lot can happen in a decade, even in its last 7-1/2 years. This is especially true when the economic stars are aligned as they are now.

There's no denying that most investors who entered the stock market over the past 30 months are now suffering losses. It's also true that they will need substantial gains to get back to even, much less realize any gains. But similar situations occurred in the past yet there are only a handful of negative ten-year holding periods. Why should the current decade be any different?

Clearly there's no assurance the next decade will ultimately be kind to equity investors. Nevertheless, given the current economic environment and market context, it's hard to bet against a technique that's worked almost 90% of the time. It's still a little too early to proclaim the death of buy-and-hold.

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