O ver the last decade, the stock This doesn’t happen because stock doesn’t have to be spectacular, just more market has earned the title of Lost market gods want to play a practical or less average), brings terrific returns to Decade. The next decade will joke on gullible humans, but because, as jubilant investors. Range-bound markets not be much different from the last: The the daily noise subsides, stock prices in follow bull markets. As clean-up guys, U.S. stock market will set record highs the long run are driven by two factors: they rid us of the high P/Es caused by bull and multi-year lows, but index investors earnings growth (or decline) and price- markets, reverting them down towards and and buy-and-hold stock collectors will to-earnings expansion (or contraction). actually below the mean. P/E compression find themselves not far from where they Though economic fluctuations have (a staple of range-bound markets) works started in 2000. We are in a Cowardly been responsible for short-term market against any earnings growth that occurs, Lion market, whose occasional bursts of volatility, long-term market cycles were resulting in zero or near-zero price bravery are ultimately overrun by fear that either bull or range-bound if the economy appreciation plus dividends. These results leads to a subsequent descent. was growing close to the average rate (see come with plenty of cyclical volatility Every long-lasting bull market, except Graph 1). along the way. one, over last two centuries (including This distinction between bear and The 1982-2000 bull market ended at the supersized one from 1982 to 2000) range-bound markets is seldom made, the highest P/Es ever. Thus, it will take was followed by a range-bound market but it’s extremely important. One should longer than usual for earnings growth to that lasted about 15 years. The Great invest very differently in each market— deflate them. Though continued economic Depression was the only exception. more on this later. growth appears to be a wildly optimistic Despite common perception, secular Prolonged bull markets started assumption, given what is taking place markets spent a lot more time in bull or with below-average P/Es and ended in the economy, it is not particularly range-bound phases, roughly half in each. with above-average P/Es. This vibrant unrealistic to assume that we will see They only visited a bear cage on very rare combination of P/E expansion and nominal economic growth over the next occasions. earnings growth (the latter of which decade. The Fed and our government are Graph 1 working very hard to achieve that, at any cost. Bear markets are range-bound markets’ cousins; they share half of their DNA in high starting valuations. However, where in range-bound markets economic growth helps to soften the blow caused by P/E compression, during secular bear markets the economy is not helping either. Economic blues result in declining earnings, which throw water on an already dying fire (the compression of high starting P/Es), and this combination brings devastating results to investors. A true, long-lasting bear market has not really taken place in the U.S., but it did occur in Japan, where stocks declined gradually, and not so gradually, at times. Japanese stocks have fallen over 80 percent from the late 1980s until today. If the U.S. economy fails to stage a comeback with at least some nominal earnings growth over the next decade, Continued on page 24 22 Napfa advIsor aprIl 2010 I Investing Continued from page 22 what started as a range-bound market in 2000 will turn into a bear market, given Finally, if earnings were to be as projected, we’d be following the last stocks to above-average valuations, causing P/Es to expand beyond their the high valuations that are in place. recession’s recovery path, which is unlikely. long-term average. P/Es can shoot for Let’s try to figure out the earnings The last recession was corporate, while the stars, but they don’t get there—at the power of the S&P 500. The current 2010 the current one is riddled with debt-laden late stages of the secular bull market, estimates of its operating earnings are consumers. Deleveraging the excesses of P/Es stop expanding. As earnings growth $75. I am skeptical of this number for the housing bubble, in the face of higher becomes the sole source of returns, several reasons. future taxation and likely higher interest disappointed investors start diversifying First, it is nearly double the reported rates (both byproducts of large deficits), away from stocks into other asset classes, 2010 earnings estimates of $45. The will be a lengthy process. The recovery will and a range-bound market ensues. As the percentage difference between reported be slower, and real earnings growth will be range-bound market marches on, unmet and operating numbers is the second- lower than in previous recessions. expectations reinforce disappointment in highest since 1988 (2008 holds the It is hard to know the exact earnings stocks, and P/Es are compressed to the record). During the 2001-2003 recession, power of the S&P 500, but it likely lies other extreme. Keeping this in mind, note the difference was about 50 percent. “One- somewhere in between operating and that stocks are still not cheap, and thus time” write-offs are responsible for the reported earnings estimates, and thus range-bound markets still lie ahead of us. Interest rates and inflation are secondary to psychological drivers, but they’re still important. They don’t cause the cycles, but they do help to shape their duration and the valuation extremes that stocks achieve. For instance, if, at the end of the 1966-1982 range-bound market, interest rates and inflation had not been in the mid-teens, the range-bound market would have ended sooner, at higher P/Es. On the other hand, if, in the late-1990s, interest rates and inflation had not been scraping low single-digits, the bull market would have ended sooner and at lower P/Es. The higher inflation and interest rates that are around the corner will take their toll on the duration and final P/E of this market as well.
What Investors Should Do
In range-bound markets, as P/Es compress, they turn against investors. In this difficult environment, investment difference. It is very likely that these “one- closer to $60. This would put the P/E of strategy needs to be adjusted for the new time” charges are not really “one-time”; the S&P 500 today at about 19. investment reality. Here are things that thus, operating estimates overstate the true Since 1900, stocks have spent very investors can do: earnings power of the market. little time at what is known as a “fairly • Become an active value investor. Second, 2010 estimates are only valued” P/E of 15. In fact, they have spent Traditional buy-and-forget-to-sell (hold) slightly below the all-time high earnings less than 27 percent of the time between P/ strategy is not dead, but it’s in a coma, the S&P achieved in 2007, when our Es of 13 and 17. They only saw a P/E of waiting for the next secular bull market economy was under the influence of 15 when they went from one extreme to to return, and it’s still far, far away. Sell several bubbles which severely inflated another. Most importantly, they’ve never is not just another four-letter word; sell corporate profit margins to unprecedented stopped at the average and gone the other discipline needs to be kicked into higher levels. Also, the bulk of excesses in direction; they’ve continued their journey gear. margins in 2007 came from the financial, to the other extreme. • Increase your margin of safety. materials, energy, and industrial sectors— During secular bull markets, Typically, value investors seek protection the ones that are struggling today and will investor optimism, bundled with constant from overestimating the “E,” earnings. In continue to do so for a long time. reinforcement from rising prices, takes this environment, protection needs to be
24 Napfa Advisor April 2010
Mean Reversion I Investing beefed up to accommodate the impact of constantly declining P/Es. • Don’t fall into the relative- valuation trap. Many stocks will appear cheap based on past valuations, but past secular bull market valuations will not be in vogue for a long time. Thus, absolute-valuation tools such as discounted cash-flow analysis should carry more weight. • Though timing the market is alluring, don’t try it. Market timing is very difficult to do consistently. Value individual stocks instead. Buy them when they are undervalued, and sell them when they become fairly valued. • Increased margin of safety and stricter selling discipline will lead investors to have a higher cash position at times. Don’t invest for the sake of being invested, because this will force you to own stocks of marginal quality or stocks that don’t meet your heightened required margin of safety. Secular bull markets taught investors not to hold cash, as the opportunity cost of doing so was very high. However, the opportunity cost of cash is a lot lower during a range-bound market. And what if a range-bound market isn’t in the cards? If a bull market develops, active value investing should do at least as well as buy-and-hold investing or passive indexing. In the case of a bear market, your portfolio should decline a lot less.
Vitaliy Katsenelson is a director of
research/portfolio manager at Investment Management Associates, Inc., a value investment firm based in Denver. He is the author of Active Value Investing: Making Money in Range-Bound Markets, published by Wiley & Sons. His insights on value investing, as well as on investing in China, Russia, and Japan, are regularly featured in major business and investor publications. For more information, go to contrarianedge.com.
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