Buy and Hold: Lessons from Japan

In the 1980s, "Japan Inc." was a popular term used to describe the strength of corporate Japan and the country's economic system. Volumes of books were written on why the Japanese economic system should serve as a model for other countries. By the start of the 1990s, Japan entered into a stagnation that has lasted for over twenty years.

The length of Japan's stagnation has likely surprised even the most bearish of Japanese observers. Many investors have made rational and well thought out cases for shorting Japanese bonds. The basic premise has been that the country will have to inflate its way out of its debt problems or default. So far, Japan has managed to beat the odds. However, in August 2011, Japan did receive a debt downgrade from Standard & Poor's. What is not mentioned very often is that there is a new "Japan Inc." emerging in which Japanese corporations are more transparent in their governance and more shareholder friendly than ever before.

For Japan's stock market, it has been a long steady decline since it peaked in 1989. The interesting fact that emerges from looking at the data on the Japanese index is that despite it having fallen from 39000 to 8000 over the last 22 years, Japan has experienced many rallies over 20% and some that were over 50% in magnitude.

It can be argued that the "Japan" of this decade is Europe. Only there never was a preceding "Europe Inc." Europe's economy as a whole has mounted a lethargic response to the challenges of competing in a globalized environment. Perhaps no country symbolizes Europe's stagnation like Italy. Since 1961 to Q1 2012, it has averaged an annual GDP growth rate of only 2.7 percent. By comparison, Canada managed to grow at an average of 3.34 percent annually for the same period.

Financial markets around the world have been experiencing a "lost decade" where stock markets have been range bound. As the chart above shows, in some countries, the markets have not been range bound -- they have been in a long period of decline that has lasted for over a decade.

Increasingly, some are questioning the "Buy and Hold" mantra that was so freely espoused in the 1990s during a nearly two decade old bull market. These long term bull markets were accompanied by books such as "Dow 36000" and "Stocks for the Long Run." It is easy to see why "Buy and Hold" and indexing were so popular during a time when markets seemingly only went up. During a secular bull market, investors pay ever increasing multiples for corporate profits causing stocks to rise. Today, it is the opposite and valuations are being compressed.

What investors need to realize is that secular (long term) bear markets have arisen throughout history and follow secular bull markets. This time is no different. But like every other secular bear market, it will end as investors give up and vacate stocks for bonds and other income investments -- regardless of the fact that bonds at these levels simply do not add up as a rational response.

According to data from the Investment Company Institute (ICI), since January 2008, about $409 billion has flowed out of equity mutual funds while about $895 billion has flowed into bond mutual funds in the US. Income has become a focus for most investors whereas in the 1990s it was an after-thought. Currently, 40% of the S&P 500 companies and much of the S&P/TSX 60 is yielding more income than bonds while trading at fairly attractive multiples. The same way that those who ignore history were wrong about "Buy and Hold" -- there will come a time that "Buy and Hold" is the correct response.  It is not yet that time but equities are attractive, bonds are expensive and yet the investment crowd continues to shun equities.