When 'buy and hold' simply doesn't work

Just as greed chased markets across the world way above their fundamental valuations, we reckon there’s a good chance that fear will chase them all the way back down.

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Up until last week, global stock markets had been ignoring the carnage in the credit markets.

Not anymore. Yesterday the FTSE 100 had its biggest single day points fall in five years. It dived more than 200 points - wiping out all the progress made since March. The FTSE 250 had the worst points fall in its history, slumping 382. And in the US, the Dow Jones Industrial Average lost more than 300 points - plunging by up to 440 points during the session.

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US Treasury Secretary Hank Paulson - the man who has been claiming since the start of the year that the US housing market woes are "at, or near the bottom" - tried to shrug off the falls. "We are always going to have volatility," he said.

Well, better get used to it, Hank - because there's a lot more where that came from

As world stock markets were plunging, on the domestic front, we learned that rising interest rates are starting to bite. The Nationwide house price index saw its lowest monthly gain - 0.1% - since April 2006. The annual growth rate dropped sharply from 11.1% to 9.9%.

And a swathe of corporate reports warned of increasing pressure on consumers. Kingfisher, Kesa Electricals and Bradford & Bingley, among others, warned that interest rate hikes were starting to take their toll.

Of course, companies will say that - at times like these, when you're not sure of just how bad things might get, it's often a better idea to play up any potential crisis so the market's pleasantly relieved if the worst is avoided. But this time, it looks like pleasant surprises will be hard to come by.

The Telegraph quotes Robin Evans of Foxx-Pitt Kelton, who warned that "growth in the UK could slow quite sharply into the end of this year and the beginning of next year." Retailers may come under "concerted pressure" in the autumn, said the paper, as indebted consumers tighten their spending after the summer holidays.

Meanwhile, private equity firms Apax and Permira, who failed to sell fashion retailer New Look at auction earlier this year, have shelved a short-term refinancing package that would have allowed them to extract another dividend out of the company. They may soon wish they'd taken one of the few offers that they did get for New Look. And we've just heard this morning that Cadbury Schweppes has stopped the sale of its US division for the time being although interest has been strong' apparently, "the leveraged debt markets have experienced extreme volatility in recent days. As a result, a decision has been taken to extend the sale timetable to allow bidders to complete their proposals against a more stable debt financing market," it said. There's no date for when the auction might restart, as yet.

To compound the misery - though it was all but lost in the sea of worry surrounding fears that private equity firms can no longer afford to buy their way through the worlds stock markets - news came that the number of new home sales in the US fell by 6% last month.

So what's it all boil down to? In City-speak, "we're seeing a global repricing of risk as the cost of capital ratchets up," said Joseph Quinlan at Bank of America.

In other words, greed has turned to fear. And just as greed chased markets across the world way above their fundamental valuations, we reckon there's a very, very good chance that fear will chase them all the way back down and below their fundamental valuations.

It's at this point that you remember why it's a good idea to buy near the bottom of the cycle, when asset prices are falling, using cash rather than debt. If the price of your asset falls, it doesn't matter, because you don't have any debt payments to service. You can just sit on it until it finally goes up. You know it's worth more than you paid for it - it's just a matter of time before the market realises that too.

The problem with buying on the greater fool' theory, and being too scared to be out of a market because it might keep going up - as has been happening in recent years - is that you end up borrowing money to buy overpriced assets. For example, recent entrants into the buy-to-let market say they don't mind subsidising their tenant's rental payments, because they're "in it for the long-term." They don't mind potential short-term' capital falls, because they're "in it for the long-term."

But buy and hold is a very flawed strategy if the asset you're holding isn't actually worth the price you paid for it. And it's worse still if you are holding it using borrowed money. The greater fool' theory of buying and selling depends on you finding another, more eager person to sell to for a higher price as quickly as you can.

If you just sit on an overvalued asset, it's only a matter of time before the market realises that it's actually not worth what you paid for it, and marks it down accordingly. Then all you're left with is a huge debt to service, usually at a time when suddenly your job looks less secure, debt servicing costs are rising and creditors are much less sympathetic than when they loaned you the money in the first place.

Turning to the wider markets

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The FTSE 100 fell 203 points to 6,251. Insurer Legal & General was the top faller, shedding 12p to end at 138p, after first-half new business figures missed City estimates. For a full market report, see: London market close

On the Continent, stocks also fell sharply. The ParisCAC-40 shed 162 points to close at 5,675, and the FrankfurtDAX-30 plunged 184 points to 7,508.

Across the Atlantic, the Dow Jones fell 312 points to close at 13,473. The tech-laden Nasdaq was 48 points lower, at 2,599, and the S&P 500 fell 35 points, to 1,482.

In Asia, this morning, the Nikkei 225 fell 418 points to 17,283, with exporters particularly hurt on fears about the US economy.

Crude oil was trading at around $74.86 this morning in New York, while Brent Spot was at $75.74 in London.

Spot gold was trading at around $662.50 this morning. (For in-depth daily gold reports, see: investing in gold. Silver, meanwhile, was trading at $12.74.

In the currency markets, the pound was at 2.0375 against the dollar and 1.4863 against the euro this morning. And the dollar was at 0.7298 against the euro and 118.93 against the Japanese yen.

And in London this morning, natural gas group BG Group reports that second-quarter profit rose 13%, helped by higher shipping volumes of liquefied natural gas (LNG) to the US.

And our two recommended articles for today...

Why the world still needs coal

- When it comes to energy, oil hogs the headlines. Yet the world is also heavily reliant on coal, and coal stocks may be worth a look: Why the world still needs coal

Swim with the sharks but risk being eaten alive

- Many of the big financial players have recklessly used leverage and risk with other peoples' money to book corporate profits. Richard Benson asks how they could get away with it: Swim with the sharks but risk being eaten alive

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.